Book Reviews | Oct 23 2024
Managing your risk when borrowing to invest
Edited extract from Virgin Millionaire: The step-by-step guide to your first million and beyond by Ben Nash (Wiley, $34.95), available at all leading retailers.
Borrowing to invest is one of my favourite strategies, and I believe it is an important aspect of the journey to real money success. But you should be aware that borrowing to invest involves risk that needs to be carefully managed.
There are two big reasons why using smart debt as part of your investment strategy should be on your radar:
-Smart debt accelerates your wealth building: when you borrow money to invest, your end up with more investments than you could build with your savings alone. This means more investments growing for you, and therefore more investment profits.
-Smart debt gives you tax breaks: because interest costs are tax deductible, the after-tax cost of your borrowing is reduced.
Essentially there are four key areas that drive most risk. I will discuss them in some detail so you can cover your bases.
Choosing quality investments
First, choose an investment that will increase in value.
When investing in property with borrowed money, you’re effectively relying on future growth. It’s this growth that will facilitate your next investment, whether it’s buying another investment property, investing in shares, or being able to turn off your employment income tap and retire.
If you choose an investment that doesn’t grow over the long term, not only will you not make money on it, but your equity won’t grow. This will reduce your ability to borrow more to invest in the future. And because each property consumes some of your borrowing capacity, a slow-growing property can be a serious spanner in the works of your Virgin Millionaire plan.
Avoiding forced sales
Make sure you’re never forced to sell your good investment at a bad time.
The aim of any growth investment such as property or shares is to increase in value over time, and if you choose a good investment, this is exactly what will happen. But value increases don’t happen in a straight line. Ups and downs are to be expected.
Even if you have the best property or share investment, there will be periods when it’s value will decrease. It may be an effect of what’s going on in the economy in Australia and around the world, of market sentiment, of geopolitical factors, or of a huge number of other variables.
It’s important when you borrow to invest that you have money to fall back on. Your emergency fund needs to be full and you need a buffer for changes to your situation, including your finances, into the future.
If you’re forced to sell a good investment at a bad time, you can lose money.
Cashflow risk
The biggest and most complicated area of risk to manage when you borrow to invest is around the cashflow of your debt-funded investment. Any time you borrow, you will need to make regular repayments to cover your debt. These repayments impact your cashflow and savings capacity, and if you can’t cover your repayments and all your other expenses, you’ll be in serious trouble.
You may be forced to make lifestyle sacrifices. In the short term this may be manageable, but in the long term it’s unsustainable. Either way, it’s not the pathway I’d recommend for any Virgin Millionaire, and it’s unlikely to be the pathway you want for yourself.
Any time you borrow to invest, you need to ensure the investment and associated debt repayments comfortably fit within your means, not only today and next month but into the years ahead. Long-term cashflow is an area most people don’t think about as much as they should, yet it carries the most risk.
Starting a family and the costs related to children and schooling, changing jobs or careers, starting a business and relocating to a different suburb or state will have a financial impact on how much money you have to cover debt repayments and investments.
You may buy an ideal property today, but one major change can mean it’s no longer a comfortable fit. This will force you to make difficult decisions, such as selling your investment or making other sacrifices.
When setting up your strategy for buying a property, take time to consider how possible changed circumstances could impact your income and expenses. Bake this into your planning to ensure you will be able to hold your investment and reap the rewards over the long term.
Interest rate risk
In the first months of 2024, we were looking back on the fastest interest-rate tightening cycle in a generation. Interest rate increases caught most people by surprise.
Many investors in the property market were under so much pressure they needed to sell properties because they simply couldn’t keep up their debt repayments. Though they will be able to get back on track, their investing plans have been set back for years.
No one was expecting rates to increase as far or as fast as they did, but it’s also fair to say that many didn’t plan their borrowing as well as they should have.
Whenever you borrow, you need to be aware that interest rates may increase and plan your investment with this in mind. This is particularly important when rates are below their long-term average, but it’s relevant at any time.
Virgin Millionaire: The step-by-step guide to your first million and beyond by Ben Nash (Wiley, $34.95).
Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.
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