Budgeting

Credit card debt is at historically low levels, which is good news, as Australian households trim their borrowings and turn their backs on expensive interest repayments. But there’s another form of debt that’s less visible but just as much a drag on finances if left unchecked – using your mortgage as a line of credit.

For those who’ve paid off a big chunk of their home loan, it’s a favourite source of cheap finance. When borrowing to buy shares, for example, interest payments at home loan rates are much lower than on a margin loan – and not as scary as you won’t face a margin call if the value of your holdings drops below a certain proportion. The biggest danger is that these funds become “the family ATM”.

Sense of entitlement

“Sometimes when people pay extra into their mortgage, there’s a sense of entitlement that they can [redraw and] just get the money when they want to use it,” says financial planner Peter Foley, director of Third View. By using the cash to finance consumer goods, a new car or a holiday, you’re undoing any interest savings thanks to past discipline. And rolling old consumer debt into your home loan may not keep you ahead unless you lock in extra repayments.

In terms of investment, though, using a line of credit secured by your home can make sense – as long as it’s not “set and forget”. Like any other investment in this extended period of market uncertainty, such a strategy needs to be revisited to ensure it’s still doing its job – to boost your wealth creation. With markets in long lulls and asset values in the doldrums, some households may be questioning whether it still makes sense to service this sort of debt, especially if they could do with the extra cash flow.

Interestingly, financial planners seem to be less keen on this strategy, with 28 per cent of them giving advice about lines of credit in 2011 compared with 40 per cent the previous year, according to an Investment Trends survey.

But Andrew Carra, financial adviser with Carra Wealth Management, is a fan – although with certain provisos.

The golden rule

“When borrowing against your house to implement this strategy correctly, it is absolutely imperative that the objective of the portfolio is to grow the underlying income through dividend growth,” he says.

“It is for this reason that I only invest into a portfolio of Australian industrial shares with a track record of dividend growth. The primary objective of this portfolio is to get it to the point whereby the dividends cover the interest expense on the loan and the investor can then sit back and marvel at the long-term power of compounding. If you are investing solely for capital growth with no regard to dividends, then this is fraught with danger as you will always be dipping into your cash flow to cover the loan interest.”

He argues that while share prices may be falling at the moment, some company profits are increasing and flowing through to increased dividends. “For an investor this can mean they can use the dividend income to cover the interest expense on their loan. Combined with falling interest rates, this makes covering the loan interest a little easier,” he says.

Pay the mortgage off quicker

Adviser Wayne Leggett, principal of Paramount Wealth Management, adds another twist. He says not only is a home-secured line of credit the cheapest source of borrowing with the greatest flexibility, it offers the chance to accelerate the rate of repayment of non-deductible debt – the actual mortgage on your family home.

“This is achieved by structuring all deductible borrowings on an interest-only basis and driving all cash flow (salary, rent, dividends, etc) into reducing non-deductible debt,” Leggett says.

Unless you set a regular time to review whether your borrowings are boosting your wealth, it’s all too easy to lose track, says financial adviser Suzanne Haddan, managing director of BFG Financial Services. “Because the repayments are not related to the value of the assets, people can get careless and unfocused,” she says.

“There isn’t that link to remind people that perhaps they should be reducing their debt to keep their wealth position if the asset doesn’t have the same value, and that perhaps their budget needs to change.”

Constant monitoring

Margin lending – while very stressful when there is a margin call – forces a greater discipline in terms of size of loan versus value of assets.

“As with any strategy, it must be reviewed regularly to ensure it’s meeting its objectives,” Leggett says. “Sometimes situations develop where the best course of action is to effectively cut your losses. One of the hardest things to do is separate the emotion from the logic. Typically, investors are reluctant to sell an asset when its value has dropped due to the erroneous belief that it will eventually recover. Of course, this isn’t always the case.”

Carra argues that while it’s human nature to want to sell investments in a falling market, often the bleakest moments offer the most opportunity.

Your home is not an ATM

“Rather than selling quality investments in volatile times, it is an ideal time to analyse your budget and work out ways to cut back unnecessary expenses,” he says. “Sadly it is too easy to use a line of credit like an ATM, and people are too easily redrawing funds without paying any attention to paying down their debt. The value of your home is irrelevant – the value of your debt and your commitment to repaying it will determine how comfortable your life in retirement will be.”