Wednesday, June 14, 2006

Decisions on Debt #2

The previous post looked at the factors that should be taken into account in deciding whether to take on debt or to repay debt. The conclusion was that assumptions and subjective factors play a significant part in the decision making process and these factors deserve at least as much consideration as the mechanical calculations.

I recently decided that another residential property should be added to my DIY retirement fund. Leaving aside the thought process that led me to consider that residential property was a suitable investment, I then had to consider whether I wanted to gear the investment and, if so, by how much. Since I did not have enough cash on hand to purchase a property outright, I had to consider:

1.whether I should sell other assets to avoid borrowing?

2.if I borrowed to purchase, how much should I borrow?

With interest rates at about 5.5%, I answered the first question by assuming that the other assets (funds and silver) that would have to be sold should return more than 5.5% pa over the life of the loan and, therefore, I would be better off keeping the investments and borrowing to complete the purchase. I did assume that interest rates had the potential to rise further (possibly up to 7.5%). Needless to say, the subsequent dramatic declines in both stock markets and silver have shown this to be a staggeringly bad decision.

Next, I had to decide how much to borrow and on what terms. The amount of cash I had available dictated the minimum amount of the loan needed. After that, I considered the following:

1. I prefer not to have debt on retirement;
2. I do not anticipate needing any cash from my investment before retirement;
3. I should allow for some more increases in interest rates and outgoings;
4. I should be conservative in estimating the likely rental income;
5.I do not want more than (at worst) a small negative cash flow each month.

I concluded that I should gear to the point where I had a small projected cash surplus each month (to allow for rises in interest rates) and that the term of the mortgage should be close to my intended retirement date. I ended up with a target gearing ratio of 44% and a term of 12 years. If the rent is at the low end of my expectations, I will show a small negative cash flow each month. At the high end I will show a small surplus. If, after renting, the result is a negative cash flow, I can consider making a partial prepayment to address the problem.

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