Shrink debt or buy shares?

2012Posted by Tom Hartmann in Investment, Managing debt | 0 comments
The government share offer of state-owned assets is bound to drum up more interest in investing. Is investing right for you, right now? Since we now have a window of opportunity to calmly think in general about whether to invest, let’s seize the moment.
Before any talk of share price, dividends, or a business and the industry it’s in, the question of whether you ought to invest right now begins with your own financial situation. Taking a clear look at your circumstances is the best way to make an informed decision.
Simply put, it may all come down to how much debt you are carrying – especially dumb debt. Take a moment to list all the debts you may have (credit cards, hire purchase, personal loans, car loans) and the interest you are paying on each. Sorted’s debt calculator can certainly help. If you have a mortgage, take a moment to plug in the details in our mortgage manager.
Now any investment you make should be measured by what’s in it for you. After all, you need to gauge what you get in return for putting your money into something that will certainly bring some risks with it (as all investments do). With shares, returns come in the form of dividends that a company pays. There is also the possibility that those shares may grow in value over time.
There are, of course, many things you could spend your money on. But the question is, which would be better for your finances – paying down the debt that you have or investing in shares? Even before knowing the details of an investment, we can already say that to be worth it, the returns from the investment would have to be greater than the amount of interest you are paying on your borrowings. That’s a big ask.
Both the debt calculator and mortgage manager show how much interest you could save if you put your money toward paying down your debts instead. Can you be confident that your investment in shares would earn more than that? If not, paying off debt first will provide a far better result to your net worth.
Another thing to consider is that if you are a member of a KiwiSaver scheme, remember that you are already an investor. The fund you are in will typically have some mix of shares, bonds, property and cash already, so you may even find that you are already invested in a certain company without realising. Contact your KiwiSaver provider to learn more about the investment choices they’re making on your behalf.
If you are thinking about borrowing money in order to buy shares – what’s known as ‘gearing’ – be aware that it can be risky business. The vision of high returns can be fantastic, but the losses can be huge in bad times. Risks become magnified. And if you are borrowing against your house to invest, you could lose your home if the investment goes bad and you can’t keep up your loan repayments.
Here at Sorted we're fans of emergency funds – setting aside at least three months’ expenses in order to cover the unexpected, such as sudden home or car repairs, or a temporary job loss. Before starting to invest, and if you haven’t already, you should definitely consider building your emergency fund. Since money tied up in investments can be difficult or costly to free up in case of emergency, it’s wise to have an emergency fund at the ready instead.
In the end, if you find that you indeed have money saved that would be better invested than simply sitting in a low- or no-interest savings account, sounds like you’re ready to consider shares in your mix of investments. It may be time to study a given industry and choose which business you’d like to own – even if it’s just part of one (a share).

How does leverage work?

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  Borrowing to invest is also called getting leverage, or leveraging. You can leverage by:
• Going to a bank and taking out a loan. You may use the equity in your home to back up or secure the loan. If you do this, what will happen if your investment loses money? You may have to sell your home to pay back the loan.
• Borrowing money through a brokerage firm. This is called buying on margin. If you do this, what will happen if things don’t work out? You will have to put more of your own money into your account to cover your losses. Make sure you have a back-up plan for how you would handle this problem.
• Short selling. Here you borrow shares of a stock from your brokerage firm, and sell them at their current price. If the share price falls, you buy back the shares on the open market at the lower price. Then you give back the borrowed shares.
• What will you do if the shares go up, not down, in value? You will lose money. You will have to pay more to buy the shares back and return them to your brokerage firm.

Is borrowing to invest right for me?

Ask yourself these five questions:

• Do I understand how borrowing to invest works?
• Am I comfortable with the risk in the investments I want to make?
• How much interest will I pay each month? How does that compare with what I hope to make from my investment?
• If interest rates rise, will my costs increase? Will rising prices reduce what I make on the money I borrow?
• What if I lose some, or even all of the money I make with the borrowed money? Can I afford those losses? Will I be able to pay back what I borrowed from my savings?

Tip: Before you even consider borrowing to invest, make sure you understand the basics of borrowing. For example, there are real dangers to using your home to borrow.

How self-funding instalments work

Investors purchase the SFI in two instalments. The first is paid upfront and is typically around 50 per cent of the cost of the underlying security. It also includes a premium for the protection referred to above.  Investors also commonly pay the first year of interest upfront, although some products offer interest loans with monthly repayments.

Paying the second instalment is optional. You pay it if you want to own the underlying shares or units outright. Alternatively you can sell the SFI on ASX at any time.

For high-dividend shares such as Telstra and the top four banks, the second instalment will reduce over time, resulting in a smaller optional second payment.  For shares that reinvest profits and pay smaller dividends to investors, such as BHP Billiton and Rio Tinto, the second instalment may remain the same or increase slightly as interest is capitalised to the loan.

Ongoing interest is charged once a year and is automatically added to the loan. Dividends or distributions paid by the underlying securities are used to reduce the loan. Interest deductions and franking credits can be used to reduce the tax payable by an individual or SMSF.

Any capital gain from shares that have increased in value above the loan amount can be retained, depending on personal circumstances.

What are the Benefits vs Risks of borrowing to invest?

What are the benefits of borrowing to invest?

You may ask why you would want to hold a negatively geared asset if it is making a loss. There are two main reasons:

You may be entitled to offset any loss you make on one investment, against other income, resulting in tax savings.
Over time, the capital growth of the assets means that you can sell the asset for a capital gain that more than covers the losses over the time held.
Other benefits of borrowing to invest can include:

If the investment is positively geared you have access to a passive income stream that can provide you with greater lifestyle choices
By borrowing to invest the capital growth potential of your assets is greater because of the greater capital base to begin with.
 What are the risks of borrowing to invest?

While the benefits of gearing into an investment are attractive, there are risks which you need to consider:

Borrowing to invest can increase losses if the value of the investment drops significantly.
You could be subject to a margin call if you have borrowed through a margin loan (explained in more detail on the margin loan page).
By borrowing to invest in one asset such as an investment property, you may be reducing your exposure to a diversified investment portfolio.
You may have limited access to your funds, if your investment is large and illiquid such as property.
As long as you are aware of the risks you can be prepared to manage them or wear the consequences. If you are unsure then talk to others or get some advice.

Capital protection is no guarantee

Capital protection does not mean you can't lose money. If markets decline such that you need to exercise the put option, you will lose the money paid for borrowing costs and the put option premium. This limits the downside to a known amount but does not eliminate loss altogether. If you want to eliminate losses due to sharemarket falls altogether, then stay with term deposits.

Near or at-the-money put options for high-dividend shares over the medium term being considered in this article, particularly given current market volatility, are generally expensive. The additional costs can erode the potential gains that were the initial purpose of the strategy.

Protection strategies became topical after some investors experienced difficult margin calls during the GFC. This may be an overreaction. The yield strategy outlined in this article is based on a modestly geared, reasonably diversified portfolio of blue chips with a record of earnings and dividends. Even precipitous falls similar to those in 2009 are unlikely to result in a margin call for this style of share portfolio.

More importantly, all investment strategies, whether term deposits or shares, should not be "set and forget". Certain strategies require more monitoring and adjusting. In a gearing strategy, a margin call is an "automatic adjustment" of last resort. Investors should consider setting portfolio review points.

As gearing drifts from the 50 per cent target up to 60 per cent, for example, a review is triggered, potentially resulting in a decision to reduce the loan by selling shares. A fall to 40 per cent gearing would trigger a similar review.

Competition for term deposits has created some very attractive safe havens for investors' cash. Financial markets have moved on, interest rates are down, and dividend yields may again be attractive.

What Is Margin Lending?

Margin lending involves borrowing money against shares you own - in order to purchase more shares. In effect it enables you to build a portfolio where, depending on your specifications and the financial institution, your borrowing level can range between 30 - 80 per cent of the portfolio's value.

Once the investor specifies how much of the portfolio they want to leverage, a loan level is set to buy shares up to that leverage level, and interest is payable on that sum. Financial institutions set minimum loan levels for margin lending.