Thursday, February 22, 2007

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.

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