Worry-free level of gearing
QBoth myself and my wife are 32 this year and currently have no kids. Our home is valued at around $400,000 with only $35,000 left to pay on the mortgage. My income is $104,000 and my wife’s is $65,000 (both excluding superannuation). We both salary sacrifice $100 to super each week.
We have $25,000 in a diversified number of passively invested shares. Our plan is to borrow $25,000 against the equity in our own home each year (this value will go up in line with our salaries) to invest in more shares/ETFs. Do you think this is a good plan or should we take on more risk and borrow more to invest (in either the stockmarket, real estate investment trusts or a property)?
You have hit the nail on the head, Duncan. It is all about your attitude to risk. Clearly, you could pay down your mortgage, meaning you effectively earn the interest rate on your mortgage – I would suspect that is about 4.5%. So to make a decision not to pay down the mortgage, or to borrow against your home, meaning your mortgage goes up, you need to believe you will earn more than the 4.5% interest charged by a competitive lender.
If we look at long-term investment returns, both shares and well-located property have certainly done much better than this. So over time it is reasonable to expect that good investments should return more than the interest you are paying. This could lead to the view that “the more you borrow the better”. This is likely, but not guaranteed, to happen in the long term. The problem is, of course, if you borrow large amounts and markets fall sharply, as they can, and of course interest rates could go up.
If you were to sell in a downturn, your gearing will lead to large losses. The right amount to borrow is based on your and your wife’s personality and attitude to risk. Make an assumption that interest rates go up and the market falls significantly, say 50%. If in that situation you would hold onto your investments and not be concerned, then you have found the right level of borrowings for you.