Borrowing to invest (in property or shares) is typically a good wealth accumulation strategy as long as you do it prudently and adopt a proven methodology to select quality investments. If used wisely, debt can be a very effective tool. However, whilst your investment strategy might require you to get into debt, the strategy must also articulate how you will get out of debt (i.e. repay it). This blog sets out some of these strategies.
How much debt is safe to take into retirement?
You must think about your interest rate sensitivity in retirement. For example, if you have $2 million of borrowings, an interest rate increase of 1% will cost you an extra $20,000 per year. If your only source of income is from investments and super, that increased amount of interest might have a big impact on your cash flow and standard of living.
Generally, you want to aim for a debt level that is far less sensitive to changes in interest rates. Worrying about interest rate changes is the last thing you want to do in retirement.
One thing I always aim for when developing a strategy is that I definitely do not want any negative gearing in retirement. That is, your investment property portfolio (if you have one) should at least be paying for itself i.e. rental income covers all expenses including loan repayments. It doesn’t necessarily have to generate a lot of income (depending on the client’s situation of course), but we don’t want to be in a position where your property portfolio is sucking out cash flow.
Having zero debt might not be an optimal strategy either. A conservative amount of leverage will allow you to build wealth more aggressively, particularly in the first decade of retirement. I would argue however that you want to aim to have more conservative levels of debt when you are retired (compared to when you are working).
Debt repayment tactics
When formulating a long-term investment strategy for my clients, there are a number of strategies we can employ in the strategy that allows us to reduce debt to an acceptable level prior to retirement.
Buy an asset specifically to sell
Selling assets to repay debt solves one problem (i.e. reduces debt) but can create another i.e. it might mean that you have insufficient remaining investments to fund your retirement.
However, if you formulate a strategy from the beginning that is premised on the idea that you will sell an asset as a debt reduction mechanism, you can proactively plan around this. Firstly, it would be wise to focus on ways to reduce your Capital Gains Tax (CGT) liability such as owning the asset in a family trust, tenants-in-common or in your super fund. Secondly, you can select the most appropriate asset and location that best suits this strategy. For example, if you are planning to sell the asset in 15 years’ time then I would consider buying a house that you could add value to (e.g. renovate, sub-divide or develop) – so that you were not totally reliant on the market to generate equity in the property.
Owning that house in a super fund would mean that you could avoid CGT altogether if you dispose of the property post retirement (in pension phase). For example, if you purchase a house in a blue-chip suburb in Brisbane for $850,000 and it appreciates in value by 7% p.a., I estimate you will net circa $1.4 million in cash after repaying the loan and all costs if you sell it in 15 years’ time. That should be enough to make a significant reduction to your debt.
Use surplus cash flow
You can direct some or all of your surplus cash flow into offset accounts to notionally reduce your debt. As discussed in my blog last week, good cash flow management is imperative to build wealth. Directing monies into offset accounts does two things. Firstly, it reduces your net debt exposure and cash flow sensitivity to changes in interest rates. Secondly, it improves your investment portfolio’s liquidity because you have immediate access to cash should you require it. This might help you transition to retirement before you have access to super (which is age 60 if you are born after 30 June 1964), for example.
Withdraw some monies from super
After age 60, you can withdraw your super tax free. Depending on your super balance, debt exposure and other investments, it may be appropriate to withdraw funds from super to repay debt. Of course, in retirement, super is a zero-tax environment (if your balance is less than $1.6 million), so it’s wise to keep as much money in your super account for as long as possible. However, this might be a good ‘plan B’.
Reduce debt so investment property/s cash flow is neutral
Generating good returns from investing in property can take many decades. That is because compounding capital growth takes at least 10 to 15 years before it starts to produce significant equity gains, as described in the short video below.
Therefore, one strategy could be to reduce your net debt (through depositing surplus cash flow into offset accounts) to the extent that the rental income is sufficient to pay for the property’s expenses and loan interest i.e. break-even. This means you will be solely reliant on your super to fund say the first 10 to 15 years of retirement after which, the property should have benefited from significant equity growth over that time (assuming it’s an investment-grade asset).
Downsize your home
I am very cautious about formulating a strategy that relies upon crystallising equity from downsizing the family home. The reason being is that whilst people might like to downsize in terms of accommodation size, it might not necessarily translate to a downsize in terms of value. For example, if your family home is worth say $2 million, an alternative new-build, luxury townhouse in the same area might cost say $1.5 million. In this case, net of costs, you may not crystallise as much cash as you expect.
However, in some limited situations, where appropriate, I will assist clients in formulating a strategy that includes downsizing the family home and using some of the proceeds to reduce debt.
You need more than one tactic
You must adopt more than one of the above debt reduction tactics. That way, if one fails, you always have a plan B. For example, you might rely on cash flow to reduce debt. If that doesn’t end up delivering the amount of debt reduction desired or expected, then you can withdraw monies from super or sell a property for instance.
What is your plan?
Many financial plans require investors to get into debt. However, a plan is not complete if it doesn’t address how the investor will eventually repay their debts at some point. And if you want to retire within the next two decades, debt reduction is something you need to start considering, if you haven’t already done so. Of course, we are here to help, if you need it.