Wednesday, June 05, 2024

How the rich use debt to get richer For many people, debt is a scary word

“We can easily forgive a child who is afraid of the dark; the real tragedy of life is when men are afraid of the light.”

― Plato

How the rich use debt to get richer For many people, debt is a scary word. But debt can help build wealth so long as you’re careful about it.

For long-time investor Peter Thornhill, using debt to his advantage has been the strategy through which he has built wealth. The 77-year-old has used the equity built up in the three homes he has subsequently owned in Australia since his return from working in London in 1988 to invest in the sharemarket and, he says, the result is that he paid off his mortgage “decades ago”.

The practice, known as debt recycling, involves paying down the non-tax-deductible home loan debt on your principal place of residence, either in full or substantially, and then borrowing against it at home loan interest rates to buy investment assets, such as a property or shares, thereby turning non-tax-deductible debt into debt that is tax deductible.
Investor Peter Thornhill has used debt recycling to grow his wealth for almost 40 years. Louie Douvis
“I used it almost from day one when we bought our first house,” says Thornhill, who is a well-known financial commentator and author of Motivated Money, a book that is particularly popular with devotees of the financial independence retire early (FIRE) movement.
The strategy Thornhill has followed is to use the equity in his home to buy listed investment companies that invest in dividend-paying shares. The dividends are paid directly into the loan to help cover the repayments, and he continues to withdraw additional equity to increase the size of his share portfolio. He says the strategy “blasts through debt” and Thornhill’s son has paid off his first home in just 10 years by following the same debt-recycling strategy.
Ben Smythe, a partner and principal adviser at Minchin Moore, says while borrowing against a home may be considered high-risk by some, the key to employing a debt-recycling strategy successfully is having strong cash flow, as repayments need to be made before they can be claimed back at tax time.
Even though such loans are typically structured as interest-only to lower the repayments, it is cash flow that ensures servicing the debt is not problematic, he says.
Unlike Thornhill, Smyth advises clients to use debt recycling to invest for capital growth rather than yield, so favours investment in property rather than shares. He says the strategy is most suitable for a very particular type of client, people he describes as “wealth accumulators”.
They are typically aged between 40 and 55, have strong cash flow, either from their salary or their own business, and have previously been focused on paying down their home loan aggressively. They also need to have a reasonable tolerance for risk because “borrowing magnifies the risk of downside, but it also magnifies the upside opportunity as well”.
“They’re looking to really focus on wealth accumulation aggressively going forward, now that their kids are a bit older and their mortgage is under control while they’re still earning really good cash flow,” Smyth says.
He says the strategy is best for mid-lifers or younger pre-retirees rather than anyone closer to retirement because “it’s important to have time on your side in order to allow the investment to earn that capital growth”.
Head of personal finance at Morningstar, Mark La Monica, agrees that debt recycling – sometimes called equity extraction – can be a useful strategy in some circumstances, but can be dangerous to employ without expert advice.
“You are introducing a lot of risk into your personal finances and mainly that risk is around servicing that debt,” he says. “Cash flow is the biggest issue that people need to worry about and there’s a big difference between being a tenured professor and being somebody who works in sales and earns a high commission.”
Ben Smythe, a partner and principal adviser at Minchin Moore, says strong cash flow is key to using debt recycling successfully. 

The risks of debt recycling 

While acknowledging that debt recycling carries some risk, Smythe says steps can be taken to reduce it. He suggests investors considering it face the risks upfront by asking themselves the following questions:
  • Will you still be able to service the debt if you lose your job?
  • What will happen if your investment doesn’t produce the return you’re expecting, and you have to sell at a loss?
  • Can you afford to absorb a rise in interest rates?
“If you’re in your 50s, and you lose your $500,000-a-year job it’s pretty hard to get another $500,000-a-year job,” Smythe says, in relation to assessing whether you can service the debt. “Whereas in your mid-40s you probably have a better opportunity to replace that income at a similar level.”
He says capacity to absorb loss is the main reason debt recycling is best employed by people with a high net worth. Although some FIRE aficionados take a highly leveraged approach to accelerate their gains, Smythe recommends clients using debt recycling limit the loan-to-value ratio on their home to a maximum of 50 per cent to limit their risk. Should it all go wrong they may have to downsize, but they won’t lose their capacity to own a home altogether.
The ability of investors using debt recycling to absorb a rise in interest rates was put to the test recently. Smythe says some investors employed debt recycling to buy investment property when interest rates were at their post-COVID-19 lows and were then forced to sell when they found they could no longer service the debt following the sharp rise in interest rates.
In this particular instance, many investors were saved from potential financial disaster because property priceshad continued to rise alongside rising interest rates, meaning the majority would have cashed out their investment properties for a profit.
But investors should be aware that this may not always be the case. La Monica says while rising interest rates is one risk involved in debt recycling, the strategy also bets on asset prices rising, be they property prices or share prices. “Taking on debt can enhance returns, as long as things keep going up. But it can be a disaster if they go down,” he says.
Head of personal finance at Morningstar, Mark La Monica, warns debt recycling can introduce a lot of risk into your personal finances. Louie Douvis

Property versus shares 

Debt recycling is most commonly used to invest in property but Smythe says it’s important to consider an investment in the context of the investor’s overall portfolio to ensure it is adequately diversified.
“A lot of clients, particularly in Sydney, have a pretty significant exposure to property through their own home. So we would typically suggest they diversify their overall wealth so that they’re not just 100 per cent in Sydney property,” he says.
Smythe says investors contemplating debt recycling should also take into account liquidity when considering where to invest, in case they are forced into a quick sale. “If clients need cash flow for an emergency you can’t sell a bathroom to extract $100,000, but with a share portfolio, you can take $100,000 out or whatever is needed along the way without really jeopardising the strategy.”
That said, while investing in the sharemarket may offer better liquidity, it tends to be accompanied by greater volatility.
Transaction costs are another key consideration, Smythe says, that should be factored in when people are considering the return required to make debt recycling a sound strategy.
Property investment carries high transaction costs associated with buying and selling, such as stamp duty and real estate agent commissions, while there are also costs in maintaining a rental property, managing it and the risk of periods of vacancy. “You need to be alive to the fact that you’re investing in order to chase return and, on that basis, ask whether a particular investment makes sense,” he says.
Smythe says it is best to consider a debt-recycling strategy in terms of the overall return it generates. Given the risk involved, he says the returns produced should be much higher than your cost of living.

The mechanics of debt recycling

  • Debt recycling aims to optimise financial gains while minimising tax liability.
  • If you own a home worth $1,000,000 and have $300,000 left on the mortgage you have $700,000 of equity in the property.
  • You release some of this equity by re-borrowing $500,000 against your home, at home loan interest rates, and use the money to buy investment assets such as shares. 
  • Throughout the year you make the loan repayments, and receive income from any dividends paid by the shares.
  • Because you’ve used the money to invest, the interest on the loan is tax deductible when you submit your tax return.