14th August 2020
The Power of Leverage
Often people ask the question – Do I buy or rent? Do I purchase shares or property? Do I borrow to my limits or do I inject more cash as equity?
The answers to all these questions come down to each unique scenario, however one aspect that often gets overlooked is the power of leveraging and how you can utilise it to your advantage, and not the banks.
It should be noted that this blog is not intended to encourage you to go out there and borrow to get into the property market. The basis of this blog is to educate investors on one mechanical aspect that needs to be considered when borrowing forms part of your investment strategy.
To help illustrate how leveraging can assist in your investment portfolio we’ll use the shares versus property scenario. The banks consider property a less risky asset, it’s a tangible asset and the great Australian dream of property ownership is so engrained into our financial culture it ensures there is always going to be demand.
Consider a scenario where you have $100k in savings to invest and start an investment portfolio:
Equity Contribution – The banks will generally lend up to 50% (Loan to Value Ratio) of the portfolio value, so in this case you’re going to have a total portfolio value of $200k.
Increase in Market Value – Suppose the market increases 10% in value, this will give you a total Portfolio value of $220k. Less the $100k borrowing and your net equity position is $120k, so you’ve made $20k.
Decrease in Market Value – Suppose the market decreases 10% in value, this will give you a total Portfolio value of $180k and a net equity position of $80k. Given your LVR has now gone above the 50% the bank will likely ask you to contribute an additional $10k to get you back to the 50% LVR.
Equity Contribution – The banks will generally lend up to 80% (Loan to Value Ratio) of the portfolio value, so in this case you’re going to have a total portfolio value of $500k.
Increase in Market Value – Suppose the market increases 10% in value, this will give you a total Portfolio value of $550k. Less the $400k borrowing and your net equity position is $150k, so you’ve made $50k.
Decrease in Market Value – Suppose the market decreases 10% in value, this will give you a total Portfolio value of $450k and a net equity position of $50k. In this scenario however it is far less likely the bank will call in your loan to get your LVR back to the 80% and might just request a refinance where some Lenders Mortgage Insurance is paid and capitalised into the loan.
As you can see from the above scenario, whilst very simple (and all things are being held equal) it simply demonstrates how the power of leverage can work better for you in the property market as opposed to the share market.
One important point to note however, when you agree to borrow from the bank and sign for a 30 year term loan you may not realise but the majority of the interest is skewed in the earlier years. So when you consider that on average Australians move from their primary residence every 7 years, if you were to sell your residence to buy a new one and refinance your mortgage then you’re starting all over again. Sure you made some good equity and you’ve upgraded your living standards but there’s no doubting who the real winner is – the shareholders who get a piece of the billion dollar profits posted by the banks.
Nevertheless, structuring your borrowings correctly and leveraging the right assets in your investment portfolio can provide you with a tax advantageous outcome. Other factors such as various state taxes, duties and also asset protection all need to be considered. Before embarking on any investment acquisition strategy we would always strongly encourage our clients to give us a call beforehand
This article is general in nature and should not be relied upon in making an investment decision. We strongly recommend you seek financial advice prior to making any investment decisions.