Debt is a good thing (in moderation)

Many people rant about the negative aspects of being in debt. Where the debt has been racked up to fund an unsustainable lifestyle (overly large mortgages, credit cards with carried balances, payday loans etc), viewing debt as an absolute bad thing is, perhaps, understandable.

I do not share that view. In most cases, the culprit is not the debt but the decisions which led to the debt being incurred. I view debt as a wonderful tool for promoting wealth creation. Here are some examples:

1. borrowing money to finance successful investments can greatly enhance returns. For those with an eye on early retirement, using leverage can add years to the time spent doing more meaningful things than sitting in an office cubicle;

2. credit cards provide a wealth of convenience - saving many trips to the bank or ATM, reducing the costs of spending in foreign currencies, discounts, points etc. And they cost nothing;

3. student loans can fund an education that would otherwise be unaffordable;

4. governments around the world would not be able to afford the stimulus packages they are currently implementing (of course, if they had wasted less of the tax payers money in the good times they wouldn't need to borrow nearly as much).

The other big benefit of debt is that debt enables investors to put money on deposit with banks and buy bonds, CDs and other interest bearing instruments. If debt did not exist, then neither would any of these forms of investment - and for most investors, deposits, CDs and bonds are the least risky part of their investment portfolio.

Of course, unless you are a civil servant, there is no such thing as a free lunch. Debt has a cost (interest) and comes with an obligation (to repay it). Without the interest cost and the obligation to repay, no one would lend money.

As much as I like debt and view debt as a positive thing, the obligation to pay interest and to repay the loan mean that too much debt can be dangerous. In some respects, borrowing money for investments is a bit like drinking red wine: a little is good for you - too much can be detrimental to your (financial) health. The latter is a point that governments who are busy racking up massive amounts of debt should pay more than lip service to - at some stage the money has to be repaid.

Mortgage refinancing

In December last year Hong Kong banks started raising mortgage rates. Prime linked mortgages were offered at higher margins than had been seen for some time and most (if not all) banks stopped offering HIBOR linked mortgages. Lending criteria were also tightened. At the time I speculated that Hong Kong may have seen the end of cheap mortgages .

In the space of four months I have been proven wrong with several banks again offering HIBOR linked mortgages. The terms are not as good as what was offered during the peak of the mortgage wars in 2005/6, but are still better than some of our existing mortgages.

The best deal I have found so far is from Standard Chartered which is offering what amounts to HIBOR + 0.8%. Importantly, they are offering borrowers the option of fixing using the 1 month HIBOR (or longer if wanted). Given the shape of the yield curve this works out at nearly a whole percentage point below what we are currently paying on our home mortgage and on one of our investment properties (about 1.2% pa).

Running the numbers for refinancing at this level would suggest we could either:

(i) keep the payments at the same level and cut the term of both mortgages by about 18 months for one mortgage and and 21 months for the other;

(ii) keep the term the same and reduce the payments, freeing up the difference for other investments.

Given that I can find plenty of relatively low risk investments with much better yields than the interest payable on the mortgage, (ii) looks the better option. (If I wanted to push this line of thought, I would extend the term to take maximum advantage of the arbitrage opportunity.)

The problem is that there is a mismatch between the exposures to changes in interest rates. The mortgage rates are (very) short term and could increase. In fact, over the term of the mortgage, I would be surprised if we do not have higher interest rates at some point. In contrast, the term of the alternative investments is fixed for longer terms (decades for some long bonds) or carries principal risk (in the case of equities). In addition, rising interest rates often result in lower capital values for both debt and equity investments, meaning that responding to rising interest rates by selling assets to repay the debt is not always an attractive option. Given that I will be carrying these mortgages into retirement, this is not a trivial risk.

That said, there is no downside to doing the refinancing. The only question is the extent to which I wish to trade off a shorter repayment period against improved cash flow.

Should I carry a mortgage in retirement?

The standard advice is that all debts (possibly excepting a reverse mortgage) should be repaid in full before retiring. My own take on this issue also tended towards the conclusion that retirement should be debt free. My reasoning is here: A debt free retirement?

Given where interest rates are today (all but one of my mortgages is currently costing me less than 3% pa) it is not difficult to persuade myself that investments in either real estate or equities should be able to produce total returns which are meaningfully above the cost of debt. There is no such thing as a free lunch, and investing rather than paying off the mortgages carries with it a higher degree of risk. The question is whether the potential for higher returns is sufficient to justify the additional risk involved. In particular, could I live (both financially and emotionally) with the possibility that the investment would show a return which was below the cost of servicing the debt?

My conclusions are as follows:

1. if there is enough margin in my budget and/or my lifestyle so that I should never need to be be a forced seller of any investments (either to make the mortgage payments or to meet lifestyle expenses), then the additional risk is reduced to the point where I would be willing to carry debt in retirement (but probably not as much as at present);

2. if there is insufficient margin in my budget and/or lifestyle to be highly confident that I would never be a forced seller of investments, then the potential for better returns is not sufficient to justify the additional risk involved.

In the latter situation, the retirement numbers are probably going to be a bit marginal in the first place and (in my case) I would prefer to work for an additional year or two to ensure that I would start in the former situation. It follows that there is a strong logical case for maintaining at least some debt in retirement (although not as much as I carry at present).

There is one other advantage of carrying some debt in retirement. The total pool of assets will be larger which allows for greater diversification and will, to a greater or lesser extent, mitigate the additional risk involved in carrying a mortgage.

There is also one very obvious risk involved. Interest rates are currently very low. In a situation where interest rates rise, it is easy to expect investment values to fall. This creates a rather unpleasant situation where expenses are rising and the ability to cut those expenses by selling investments to pay off the debt is being challenged by falling investment values. This is a very real risk and suggests that, without the back up of earned income, retirement debt should be used in moderation.

In practical terms, I could see myself keeping P+I mortgages on one or two properties in amounts that would allow the mortgage payments to be covered by the rental on those properties. If the remaining portfolio can meet our needs then, in the longer term, I would expect to gain financially as a result without needing to be materially concerned about the risks involved.

The Life and Death of a Mortgage

Here is a short story about how I managed to earn a (nearly) risk free gain on some tax arbitrage.

A number of years ago I purchased a property in New Zealand (a small brick and tile house in Auckland). It seemed like a good idea at a time when I was contemplating the possibility of retiring there. Between the appreciation in the value of the house and the appreciation of the currency, it has been a very good investment.

In the course of arranging the mortgage financing, I came across an oddity in New Zealand's tax laws:

1. as a non-resident for tax purposes, I have to pay tax on New Zealand sourced income (rent on the property)subject to a deduction for relevant expenses (interest on the mortgage). The relevant tax rate was 36% and has risen to 39%;

2. as a non-resident, I can invest in bonds and bank deposits and pay only 2% tax in New Zealand.

There are no Hong Kong taxes payable.

By opting for an interest only mortgage and putting the surplus cash flow into bank deposits rather than into principal repayments on the mortgage, I was able to earn myself a small spread.

The maths looks like this (using indicative but realistic numbers):

A. tax deductible interest on mortgage: 10% less tax effect at 36% = net cost of 6.4%

B. taxable income on bank deposit: 7.5% less tax at 2% = net income of 7.35%

Although interest rates have fluctuated a bit, the net spread has generally been slightly above 1%. Given the returns on other investments, I would have been better off investing else where, but it was still a more efficient use of funds than principal repayments.

The build up of the deposits (from rent and other New Zealand income) recently exceeded the principal amount of the mortgage. In addition, the interest expense on the mortgage has risen faster than the interest rates on the deposits, narrowing the net spread, meaning that there is no longer much advantage in preferring deposits to principals repayments. After giving the matter some thought, I gave instructions to the bank to repay the mortgage in its entirety.

So I now have a debt free property and another source of free cash flow. The New Zealand property market is showing signs of a correction. If an opportunity arises, I would consider buying another property there either next year or the year after. It's a nice country and the rent from a couple of houses would easily cover the cost of living there for a couple of months year after I retire. In effect, I would be matching income with expenditure.

Mortgages To Remain Cheap and Plentiful

Mortgage loans against residential property are both readily available and cheap. With the possible exception of the sub-prime market, I expect this to continue. There are several reasons for this - most of which are risk related:

1. mortgage loans are secured over a tangible asset. Even if the asset declines in value, there is usually enough equity to protect the lender's position (or at least most of it);

2. historically, individual borrowers have shown low default rates on home loans and, where there is a default, the loss to the lender is very low compared to other types of defaulting loans;

3. transaction costs are low. Residential loan and mortgage documents are much more standardised and less negotiated than almost any other types of loan. Transaction size (compared to credit cards and other personal loans) also provides for some economies of scale for lenders;

4. mortgage loans can be securitised which removes them from the balance sheet (freeing up capital) and, depending on the terms of the securitisation, may also remove the default risk from the lender;

5. under Basel I, residential mortgage loans receive a very favourable risk weighting (50%) which means that banks have to provide relatively less capital against residential mortgage loans than against, for example, commercial loans. Under Basel II the risk weighting for residential mortgage loans will be reduced (to 35%) reducing the amount of capital required to support residential mortgage loans and making them even more attractive to banks.

In summary, there are good reasons why residential mortgage loans are both readily available and cheap. With banks already beginning to move to Basel II there is reason to believe that this situation will continue for lending which involves sensible financials (at least some deposit and reasonable debt servicing ability). In Hong Kong the excess liquidity means that many banks have surplus capital. This has resulted in intense competition between banks both for market share and volume in absolute terms. The cost of borrowing and the terms have become progressively more favourable to borrowers like me over the last few years.

The above comments are directed at conforming or typical loans made to a borrower who is able to document the ability to service the loan and who is able to put down a meaningful deposit. The emerging problems with America's sub-prime lending market make me more hesitant to express a view on the sub-prime or non-conforming section of the mortgage market.

The case for not repaying debt #3 - my strategy

The two previous posts on this topic summarised the arguments for taking on, and not repaying, as much debt as possible and the risks inherent in that strategy .

While I recognise and wish to take advantage of the benefits of gearing, I do not wish to have to explain to Mrs Traineeinvestor why our house is being sold out from under us. My strategy is to strike a balance:

1. reduced exposure to volatility in investment values: while property prices can and do fluctuate (Asian crisis anyone?), loans secured against real estate are almost never called in by the banks unless a default has occurred. All my loans are secured against real estate;

2. building equity: although interest only loans are better for cash flow and allow for higher gearing, I recognise that eventually I will want to pay off the loans and use the cash flow from my investments to fund my living expenses. P+I loans are also available for longer terms than interest only loans which reduces roll over risk. Accordingly, all my loans are on P+I terms with one exception. The one exception was done deliberately as part of a tax arbitrage strategy. The more equity that has been built up in a property the greater the scope for renegotiating terms should the need ever arise;

3. cash flow management: I have geared most of our investment properties to the point where they have close to zero cash flow after all outgoings (including P+I mortgage payments) and allowing for vacancies. Interest rates and rents will fluctuate, repair bills will come at unpredictable times as will vacancies which means that the actual cash flow for each property may be positive or negative at various times but, taken as a whole, the geared part of the portfolio should be slightly cash flow positive. This cash flow should grow over time as rents increase. My other income (including rents from one ungeared property) is then free to fund new acquisitions;

4. mortgage duration: for a while I tried to time the duration of each mortgage to mature at or slightly before my intended retirement date. Unfortunately, this objective conflicts with the cash flow management approach (which I regard as being more important). While this can be addressed by increasing the initial equity, I do not always have enough cash available for this. The result is that I have a mix of loans that mature at or about my intended retirement date and loans that mature after my intended retirement date (in the case of my home loan, nine years after);

5. no early repayments: I have elected not to make early repayments on any of my mortgages, not even those which mature after my intended retirement date. Any additional cash flow is allocated to other investments. With interest rates at 5% or less and expected returns being higher, this makes sense so long as I have a sufficiently long time period to work with.

The above should be taken in the context of a household that has two income earners and a reasonable level of unencumbered liquid assets that could be drawn against if needed.

I actually think we are being too conservative with our use of debt but I see little risk of ever getting into financial difficulty either. I would consider borrowing to purchase a fund or portfolio of equity funds but to keep the interest costs as low as possible and to avoid margin calls will secure the advance against a property rather than the equities. Also, I would only be prepared to do so after the markets have had a meaningful correction.

The case for not repaying debt #2 - the risks

In part 1 of this post, I set out the case for maximising debt and minimising the amount of debt that is repaid. Essentially, the logic is that there is a reasonable expectation that other investments such as equities will produce returns which are higher than the interest rate being paid on borrowings.

Of course, nothing is that easy and part 2 of this post attempts to explain the pitfalls:

1. it assumes that the historic long run average returns in equities will continue to be achieved in the future. There is no certainty that this will happen. At least part of the historic long run returns on equities can be attributable to expanding valuations (e.g. higher price earnings ratios) rather than expanding earnings. This is not something which I believe can continue indefinitely;

2. it relies on average returns being achieved. Financial plans which rely on achieving average returns each year have a high probability of failure (a subject for another post I think). There have been several periods where below average returns have persisted for many years. The recurrence of a lengthy period of below average (or negative!) returns would be highly prejudicial to this strategy;

3. the interest rate on the debt is floating. Given that fixed rates are difficult to obtain in Hong Kong for periods longer than five years and prohibitively expensive even for periods less than five years, there is little that can be done to mitigate this risk. If borrowing costs rise, then the positive carry will initially shrink and may well become negative making it a losing strategy. Also, the economic conditions that produce rising interest rates (as well as the rising interest rates themselves) are the same economic conditions that may well result in a decline in the value of investments;

4. cash flow may be negative. Even though the total return on equities may be greater than the cost of borrowing, the yield received through dividends is almost certainly going to be lower. Also, interest payments will typically need to be made every month (I have one mortgage on fortnightly payments) while dividends may be received only once or twice a year. Cash has to be found to meet the payment schedule on the debt and that cash will not always be available from the investment in equities;

5. opportunity cost. Carrying high debt levels may make it harder, if not impossible, to take advantage of attractive investment opportunities as and when they arise. In particular, at times when the markets are depressed and valuations are most attractive, your loan to value ratio is likely to be at its worst and the banks are likely to be most conservative in their lending policies and practices making it harder to fund acquisitions. Another opportunity cost is that carrying high levels of debt will reduce career opportunities - in effect moving to lower paying or part time employment may be more difficult.

I have not addressed tax issues as these are more likely to be a benefit than a burden for me as a Hong Kong resident. However, investors domiciled in other jurisdictions may have to take the effect of tax into consideration in doing their own analysis.

I have also assumed that all the debt raised is secured against real estate which, based on current lending practices, will avoid the risk of a margin call.

In part 3 of this post I will look at how I balance the potential returns from using debt against the risks identified above.

The case for not repaying debt #1 - the returns

My previous post considered whether it was a good idea to make early repayments on my home mortgage and concluded that I was probably going to be better off not making early repayments. The logic for not making early repayments is (i) that the expected return on other investments is higher than the cost of the interest on the mortgage loan and (ii) with a reasonably long time period to work with, the risk of being undone by a run of below average returns on investment can be substantially (but not completely) discounted. In practical terms, the cost of mortgage finance is currently between 4.7% and 5.0% and the long run average return on the stock market is around 10%.

If this logic is correct then there also has to be a case for:

1. moving to interest only debt. This frees up more cash flow for those other investments;

2. increasing debt levels as high as the banks will allow and you can comfortably service. This puts the maximum amount of dollars to work exploiting the spread between borrowing costs and expected returns on other investments;

3. carrying debt into retirement. This would enhance my retirement income.

If the debt was used to acquire an investment property and the money not spent on principal repayments is invested in equities then, as a private individual in Hong Kong, the spread is increased by the effect of tax. The interest will be tax deductible but I will pay no taxes on the equities.

Looking through the lists of the richest people in various countries, it will be evident that many, if not a clear majority, of the people listed use considerable amounts of leverage in their investments or their businesses. Coincidence? I don't think so. In my view it is no accident, that there is an apparent (I have not verified this with a hard analysis) correlation between the use of debt and wealth. Put differently, while striving to be debt free may appear to be a worthy objective, it is unlikely to be a strategy that will maximise your return on investment or your financial wealth.

I recognise that this strategy carries with it increased risk which I will consider in part 2 of this topic.

No Early Mortgage Repayments?

Super Saver at My Wealth Builder posted about his strategy for making additional payments on his home mortgage to ensure that it is repaid by the time he retires.

We have the same issue with the remaining term of our home mortgage extending nearly 10 years beyond my hoped for retirement at 50. I do not wish to carry a home mortgage (or any other debt) into retirement. There are four ways of dealing with the issue:

1. I could make additional monthly payments calculated to achieve full repayment when I turn 50. This option may not be practical because there is a minimum partial repayment threshold;

2. I could make periodic lump sum payments every 6-12 months to achieve full repayment when I turn 50. This is the approach that Super Saver has adopted;

3. I could direct the money that would have been used to make early repayments under option 1 or option 2 into other investments. The logic behind this approach is that with mortgage interest rates well below the long run returns on equities (and some other asset classes), my net wealth will be higher at the end of the day (although not without some risk). When the time comes to retire, the other investments will be sold and used to discharge the residual balance of the mortgage (hopefully with a bit left over);

4. sell our home and buy something smaller. As our children will still be living with us at that time, this will not be an option until much later and can be excluded for present purposes.

With the interest rate on our home mortgage currently at 5.0% (it is a floating rate) and the long run return on equities averaging around 10% pa (+/- a bit depending on which market you are looking at) and a reasonable time period to work with (9 years), we have elected option 3.

We recognise that this is not a risk free proposition. Equity markets can be volatile. There have been bear markets that have lasted a long time. Even though the odds are in our favour, it is possible that the lump sum we accumulate will be less than the residual value of our mortgage. If this happens we can (i) carry a small mortgage balance into retirement (er...no thanks), (ii) sell some other investments or (iii) defer retirement until the balance has been cleared (I would not expect this to be long).

I ran some numbers comparing annual lump sum additional repayments with annual investments in other assets returning 8% per annum. The difference (after adjusting for inflation at 3%) is enough to fund a long weekend for two at a good hotel in Sanya once a year which is a nice addition to our retirement lifstyle.

Good Debt, Bad Debt

Debt is a subject that generates a lot of diverse opinions - for good reason.

My take on debt is that it can be both good and bad and it is not always possible to know in advance whether particular borrowings will be good or bad. I find it instructive that many very successful investors use debt (or use derivatives to achieve leverage) in the course of making investments. Some of them use a lot of debt. When things go well, the results can be spectacular. It is also instructive that many investors who get into financial difficulty do so because they borrowed money for their investments. The results can also be spectacular in a very different way when things go wrong.

Bad Debt

Debt that is not used to invest in assets that produce a return greater than the cost of borrowing is bad debt. It is damaging your financial position.

Good Debt

Debt that is used to invest in assets that produce a return greater than the cost of borrowing is good debt. It is improving your financial position.

Not so simple

The above distinction is simple - too simple. There are a host of factors that complicate matters. The most important (and obvious) of which is risk. It is usually very difficult to know in advance what return an investment will achieve. You may expect an investment to yield a given rate of return but it is rare to have an assurance that the expected rate of return will be achieved. If the actual rate of return is less than the expected rate of return and less than the cost of borrowing then using debt will damage your financial position - reducing the rate of return or increasing losses. There are, of course, many other risks and issues which arise as a result of borrowing.

Managing risk

I use debt. I like using debt on my investments. Use of debt means I can acquire more investments than I would be able to do without the use of other people's money. However, I am cautious and conservative in my use of debt (at least I think I am). My current borrowings all share the following characteristics:

1. they are secured against assets that are unlikely to fluctuate dramatically in value on a daily basis. At present, all borrowings are property related;

2. the assets acquired with borrowings are all ones that produce cash flow. At present, all the properties are rental properties;

3. all borrowings are on principal + interest repayment terms. The amount of equity in each property will build up over time. Eventually, each property will be owned outright;

4. gearing ratios are set at a level where the expected cash flow is greater than the loan payments. This is achieved either by increasing or reducing the equity component of the investment or increasing or reducing the term of the loan. Historically, my initial equity has ranged from 30% to 55% of a property's purchase price and the repayment terms have ranged from 7 to 20 years. In practice things do not always go as planned, but any shortfall in cash flow is likely to be too small to be of any concern;

5. all interest rates are set at the lowest available floating rate I can obtain at the time the loan is negotiated. I have looked into fixed interest loans but, in Hong Kong at least, the cost of fixing the interest rate has always been prohibitively expensive.

In summary, my approach to gearing on property is to use debt to achieve greater returns, but to limit and structure my debt so that, if things do not go as planned, I should be able to simply wait until either the debt is paid off from the rents or the market turns in my favour without feeling under pressure from lenders to accelerate payments or sell assets in unfavourable market conditions.

This approach represents my accepted level of risk in relation to borrowings. It will not put me among the ranks of the world's truly wealthy, but it should keep me away from the bankruptcy courts.