Money Matters: Borrowing to invest on property raises risks

By MARY HOLM

Q. My wife and I are considering investing in a couple of rental properties to a total price of about $400,000. Revenue is as important as growth. We could pay cash. However, my question is what sort of debt-equity ratio, if any, would you recommend in the current interest market?


A. Probably none. For the benefit of those not familiar with debt-equity ratios, the reader is asking how heavily he and his wife should mortgage the properties.

You say you want revenue from the properties. Clearly, if you get a mortgage, the repayments on it will eat into your rental income. A large enough mortgage might use up all that income, and then some.

But that's not really the issue. If you get a mortgage, you can invest your unused cash elsewhere, and receive revenue from that - in the form of interest, dividends, or by selling shares or units.

A key factor in your decision is how you would invest that unused cash.

Let's say you get a mortgage at 8.8 per cent. Because we're talking about rental properties, as opposed to your own home, you could deduct the mortgage interest from your tax.

That means that after tax the mortgage interest costs you close to 7 per cent if you're in the 21 per cent tax bracket (income of $9501 to $38,000); 6 per cent if you're in the 33 per cent bracket (income of $38,001 to $60,000); and 5.4 per cent if you're in the 39 per cent bracket (income of more than $60,000).

Can you make more, after tax, than that 5, 4, 6 or 7 per cent on the money you don't put into the properties? If so, you're better off with a mortgage.

At first glance, that might not seem hard. But you can't make that much, after tax, on a term deposit or other low-risk investment.

If you go for a fixed-interest investment with a higher return, you run the risk that interest payments won't always be made. You could even lose your capital.

If you go for an investment in shares or a share fund, your returns will fluctuate. They may well average more than 5.4 or even 7 per cent, but some months they will be negative, and probably some years too.

Simply, if you choose an investment that brings in more than the mortgage interest costs you, you will have to take some risk.

You could argue that putting the money into properties is also a bit risky these days. Property values sometimes fall. But you're taking on that risk anyway, mortgage or not. By getting a mortgage and investing your cash elsewhere, you raise your overall risk.

Don't forget, too, that mortgage interest rates may rise, which would lift your target return.

Also - and this is important - you're better off only by the difference between whatever return you make and the mortgage interest you pay. That might be just a few per cent over the long term.

Is it worth it? It depends on your tolerance for risk.

Footnote: Despite all that I've said, there is some appeal in your getting a mortgage and putting cash in a share fund. It would give you much better diversification than having all your money in rental property and your home - which I assume you own.

Q. I have just started a part-time job after taking a short time off to raise my children. We are fortunate that we do not need to use my wages to pay our living expenses.

I have increased our mortgage repayments and expect that our mortgage will be repaid in 10 years or less.

I have been through the Your Retirement Action Planner from the Office of the Retirement Commissioner and expect that if we save the amount we currently pay for our mortgage after it is paid off, until we retire, we can retire comfortably.

My question is that I have about $100 extra a fortnight that I could put on the mortgage on top of the extra payments already. Do I do that or could I invest it in an investment fund, given that we have time on our sides (we are 33 and 35)?

I know the Retirement Commissioner recommends that debt repayment be a priority, but they do so on the premise that any investment would bring only a real rate of return of 2.5 per cent.

After reading Philip Macalister's commentary in the Herald (August 12), about the return on some investment funds being around 42 per cent, it seems to me that the real rate of return for these investments must be higher than the current floating mortgage interest rates.

Therefore would it be wise for us to invest in these investment funds? I don't mind high risk and long-term investment to obtain the benefits.


A. If everyone in their thirties assessed their situation as well as you have, we'd have no worries about young people's retirement incomes. Well done.

Your question about what to do with the $100 a fortnight is actually pretty similar to the previous question, although they don't look alike.

In both cases, we're comparing investment returns with mortgage rates.

Unlike the previous question, though, your mortgage is on your home, so you can't deduct the interest on your tax return.

To do better than paying off your mortgage, you need to make an after-tax return higher than the mortgage interest rate, with no tax adjustment. It's a tougher call than on rental property.

Can you do it? Clearly yes if you invest in a fund that returns 42 per cent. No if you get the Retirement Commissioner's 2.5 per cent.

Note that the 2.5 per cent used in Your Retirement Action Planner is after-tax, after-fees, and after-inflation. It's an average rate for different types of investment. The booklet says that investors who put all their money in growth assets - shares and property - could expect an after-tax return of 6.1 per cent.

Still, the difference between that and 42 per cent is huge. How come?

First, Philip Macalister was writing about one of the best-performing funds in the past year. Many others didn't do nearly as well; some probably had negative returns.

So, you might say, "I'll go with last year's winner." Bad move. Quite often last year's top fund does poorly the next year. Winning funds tend to be higher risk ones, so their returns are more volatile than most. There's no good way of telling, in advance, which fund will do well.

Second, it's quite possible that, in years to come, the performances of all share funds won't be as good as in the recent past.

With low inflation apparently here to stay, experts predict that returns on all types of investments - fixed interest, property, shares and so on - will, on average, be in the single digits in the decades to come.

The Retirement Commissioner's numbers are based on expert research. The 6.1 per cent, then, is a conservative but reliable return to expect. And it's lower than your mortgage rate.

Still, just as in my previous answer, I'm reluctant to put you right off investing in a share fund, because of the diversification it would give you.

You're willing to take some risk, you're in a strong financial position, and you've certainly got time on your side.

Q. The article of August 19 left out a very important factor. If one elderly partner needs total rest home care, at least the house is saved for the other partner, when calculating paying care bills.

I doubt whether a rented house would be in the same category. Thus, if the couple is renting, all but $40,000 could be used up before the Government takes over the cost!


A. Your point is worth considering, but I wouldn't rate it as "very important" - especially given that the couple is obviously willing to take a few risks in life.

To get everyone up with the play, last week's reader and his wife are considering selling their house and using the proceeds to rent a house, travel, and have fun. They receive a pension that covers other expenses.

I said their plan was risky but it just might work. I must say I didn't think of how it would affect any future rest home subsidy.

What you say is sort of right. If one of the couple goes into a rest home, the Government won't pay for his or her care until the couple has used up all but $45,000 of their savings - it rose from $40,000 almost two years ago.

If the couple owns a home, they can keep it and still get the subsidy, as long as the other partner still lives in the home. But if they are renting, no specific allowance is made for that.

However, says a Work and Income NZ spokeswoman, the spouse still living in the community might qualify for an accommodation supplement to their NZ Super. That would depend on how high their rent was, how much other income they receive and other circumstances.

In any case, their NZ Super would rise from the married rate to the single rate and, if applicable, the single living alone rate, which is higher still.

For all that, in those circumstances the couple could live to regret selling their house.

It's important to remember, though, that fewer than 8 per cent of old people end up in long-term care. I'm not convinced that the couple should give up on their dream because of a fairly unlikely possibility.

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