Gearing up for a risky shot at riches

By MARY HOLM

Q: I was interested to read your column two weeks ago about your own investment history and attitudes.

It has prompted me to comment that I do not agree that the commonly held belief of paying off your mortgage and having no debt is the way to financial freedom.

On the contrary, it gets you nowhere! The vast majority of rich people have borrowed, and borrowed substantially, to get where they are.

It's not magic, just basic leverage. You have to leverage yourself to get ahead. A mortgage is the cheapest way of borrowing money and, so long as you invest it smartly and wisely, you can create wealth.

For example, I bought my first home in Auckland in 1993 for $230,000 with a $130,000 mortgage.

I borrowed another $100,000 to do it up and sold it 18 months later for $460,000, a profit of $130,000 (excluding interest).

From there I bought a house for $650,000, $420,000 of which was mortgage. I borrowed a further $150,000 to do it up. The house sold for $960,000 in 1999. Another profit of $160,000 (excluding interest).

I then bought for $1.3 million and borrowed $250,000 to do it up. I could probably sell it for $3 million. That's roughly 100 per cent profit, or $1.5 million, in 3 1/2 years, excluding interest.

All of this has been achieved through borrowing from the bank. In nine years, borrowing has enabled me to move from a $230,000 house to a $3 million house.

If I had practised the common habit of paying off my mortgage first, I would still be in my first $230,000 house, worth perhaps $600,000 now.

The point I'd like to make is: Don't pay off your mortgage as fast as you can. On the contrary, borrow more, do it up and move on. It's how rich people get rich, by borrowing and investing.


A: In many cases, you're quite right. But it's also how many formerly rich people got poor. Leveraging - which many New Zealanders call gearing - isn't the key to doing well financially. Finding the right investment is.

Gearing makes a good investment better. It makes a bad investment worse. And I hate to say it, but your history illustrates this rather well.

While your first and third houses are examples of good investments boosted by borrowing, your second house is an example of a mediocre investment made worse. You write about profits excluding interest, as if interest were a minor item.

But you borrowed $570,000 on the second house.

Your mortgage payments would have been huge by most people's standards. And a big chunk of that money would have been interest - more than enough, in fact, to wipe out your profit. Actuary Michael Chamberlain calculates that the average annual return on your second house was almost minus 6 per cent. Over four or five years, that's pretty depressing.

What's more, Chamberlain assumed a mortgage interest rate of 8 per cent. Through most of that period, the average rate was closer to 10 per cent, which would make your loss bigger.

To be fair, Chamberlain also found that that annual return on your first house was 57 per cent and, on your third house, 40 per cent - assuming 8 per cent mortgages. For all three houses, the average annual return was 19 per cent.

That's pretty nice, even if it's still less than returns on world shares, ungeared, through much of the period.

And you did, of course, get free accommodation from your houses. Allowing for that, you probably made a small profit even on the second house, but nothing to get excited about.

If, on the other hand, you had bought the same house without a mortgage, and done it up, you would have made a return of about 4 per cent, plus free rent. That's a fair bit better than you did with gearing.

There are other more dramatic cases of gearing making things worse.

In the late 1990s and 2000, when house prices fell, some people had to sell their homes or rental properties for less than their equity.

They wound up losing their deposit and still owing the bank money.

There were many similar tales, after the 1987 crash, of people who had borrowed to buy shares. That's the downside of gearing.

While we hear about those who made their fortunes with borrowed money, the ones who lost don't shout it from the rooftops.

But they are there, too. And when they borrowed, you can bet they thought they were just as clever as those who did well by gearing.

Conclusion: Gearing is only for the brave.

I prefer to take my risks by investing long-term in share funds. And so, might I add, do many other wealthy people I know. Gearing is not the only way to wealth.

Some other points:

* Reading between the lines, you must either have a current mortgage of more than a million dollars or you've injected lots of money from somewhere else.

Either way, it's not accurate to say you've moved from a $230,000 house to a $3 million house just because of gearing.

Your true gain is from the $100,000 equity you started with to $3 million minus mortgages and all the money you've put in over the years.

That would be considerably less.

You can't be sure, either, that you'd get $3 million for your current house. That top-end market is pretty fickle.

* Chamberlain questions whether you really have created wealth for yourself, or just for your children.

"In order for there to be wealth for the individual, he would have had to sell the current house and move into a $600,000 house, say," he says.

"Until he does that, it is a house. He started with a house and now just has a house (albeit a better one)."

Are you willing to trade down?

* Your sample is far too small. One person with three houses has done well. But there's probably more luck in it than you are willing to acknowledge.

I prefer to look at data for thousands of people. When you do that, the returns on houses aren't remarkable.

* You've done up your houses. People often make good profits by doing that. But you should make allowance for the time and hassle you put into it, even if you hired others to do the work.

* Last but not least, I wouldn't wave too many flags in front of Inland Revenue if I were you.

Capital gains on houses can be taxable if the IRD judges that you bought with the intention of reselling at a profit.

Your recent history, gearing and all, might look a bit suspect.

Given that you are obviously on a particularly high income, to be able to service huge mortgages, your tax rate must be 39 per cent.

Tax at that rate would put a bit of a hole in your profits.

* Got a question about money?

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