NZ Herald 22 October 2022

AYour “hurrah!” says something. It’s a good feeling to be rid of debt. So is it wise to get back into it again?

Absolutely not if you’re borrowing to buy something that loses value, such as a car or appliance or clothes or entertainment or travel. Wise people pay off that debt as fast as possible — or, better still, avoid running it up in the first place by saving first and having an emergency fund.

However, it’s different if you borrow to buy something that usually gains value — most commonly property. As long as the investment does, indeed, appreciate over time, you get the gain not just on your deposit but on the borrowed money. That’s how some people have become very wealthy through property investments.

Let’s look at an example. To keep it simple, we’ll use an interest-only loan, and assume rental income just covers interest payments, rates, insurance and maintenance.

You buy a $1 million house with a $100,000 deposit and $900,000 mortgage. The value goes up 20 per cent to $1.2 million. You sell, pay back the $900,000 loan, and are left with $300,000. Your deposit has tripled. Nice. And in recent times, house values have risen faster than that. Even nicer.

But you don’t get anything in the investment world without a downside. As economist Milton Friedman was fond of saying, “there’s no such thing as a free lunch”.

What if house prices have fallen 20 per cent when you have to sell, and you get just $800,000 for the house. You give the sale proceeds to the bank, but you still owe $100,000. And your $100,000 deposit has disappeared. I’ve known people in that situation.

You’re much worse off than if you had, instead, bought a $100,000 tiny house with no loan. If that dropped 20 per cent and you had to sell, you would still have $80,000.

Borrowing to invest, called gearing, makes a good investment better but a bad investment worse.

Note, too, that you have to make a return — from rent and capital gain — that’s higher than the interest you pay, or you’re going nowhere. In the current environment of interest rates rising and house prices falling, prospects of getting rich through property look less rosy than a few years ago.

There are also other risks. You might suddenly face a huge bill for a new roof, or to repair leaks. Or your tenants might not pay or might wreck the place. Or there’s a shortage of tenants for a while. Or rates or insurance costs soar.

Then there are possible law changes. In recent years, governments have changed housing standards, mortgage rules and taxes. What’s next?

If you buy a rental property some distance from where you live, that reduces the risk of a downturn hitting both your properties. But there can be considerable hassles running a rental from a distance — when the tenant phones at 2 am saying the roof is leaking. And even if you buy elsewhere you’re still all in property. As we’ve seen lately, house price falls tend, in the end, to hit the whole country.

So what should you do with your savings from now on? Perhaps still buy a rental property — as long as your eyes are wide open. Long-term rental investments work well more often than not.

But you would probably do just fine investing in a low-fee share fund, in KiwiSaver or via a share platform. It’s way simpler, you can easily diversify into other countries’ shares, and your money should grow healthily over the long term.

One clear advantage is that you can dripfeed your money into funds, rather than investing in a property at a fixed point in time that could prove to be bad timing. You can also make partial withdrawals if you need to.

AIt sounds as if your adviser made a basic mistake: not listening to you.

While it’s true that you might do better in rental property than in managed funds, you might not. See the above Q&A. And your objections to a property investment — lack of diversification, hassle, unsuitability in retirement — are all legit. So is your preference for staying debt-free.

Give that adviser a miss. Your plan to invest in funds sounds good to me.

AIt’s the gap between the two lines that matters, not the percentage difference between the levels, says Professor David Tripe, a banking expert at Massey University. Still, you have a point about poor old term depositors.

Let’s start with a simplified version of what’s happening. When you get a term deposit at a bank, you are lending the bank your money, and being paid interest for that. If the bank can borrow your money at, say, 2 per cent, they can lend it out at, say, 5 per cent. If they can borrow at 4 per cent, they can lend out at 7 per cent.

The difference between the two is basically the banks’ costs and profit. What stops the banks from enlarging the gap — and hence their profits? Competition.

In more professorial language, “The gap between banks’ overall funding costs and their gross interest revenues (relative to interest bearing liabilities and assets respectively) tends not to vary very much over time, and it generally covers banks operating (admin) costs and profits,” says Tripe.

However, you’re right that the gap between mortgage rates and term deposit rates has widened in the last couple of years, as the graph shows.

“During 2020 and 2021, term deposits became a less important component of banks’ overall funding, and the banks did not compete as aggressively for term deposits as in some previous periods (although they did want to retain some), as people switched their funds to on-call accounts,” says Tripe.

“That meant that the interest rate on term deposits fell by more than it might have in other periods (as can be seen in the graph), although I think that that effect is now reversing.

“One of the reasons why banks did not pursue term deposits funding so assiduously was because of the funding for lending scheme made available by the Reserve Bank.”

So perhaps you can blame the widening gap on the RB. Anyway, you’ll be pleased to know the trend is changing.

AI can’t see a clear advantage in getting a mortgage, and paying interest on it — at a pretty high rate these days — just to put off the time you sell some assets. Share prices might be better then, but they might not.

There’s no way we can ever predict what will happen in the share market. As I said in a recent column, when everyone knows the economy is likely to perform badly in the near future, that is already reflected in share prices now. Even if future economic news is not good, if it’s not as bad as predicted, share prices might rise.

In this situation, I think it’s best to spread your risk. Instead of selling all your shares now, make a plan to gradually sell them — say one sixth on the first of every month from now on. If the market drops on the date, don’t delay. It might drop further the next day.

Once you’ve sold all the shares, you’ll look back and think, “It was good we sold some that month, and bad that other month. But at least we didn’t sell the lot at what turned out to be the worst time.”

By the way:

• Ideally you would have gradually sold the shares some time ago, so you wouldn’t find yourself having to sell in a down market. But perhaps you decided only recently to use the shares for this purpose.
• Your balanced fund will also hold lots of bonds and probably some cash as well as shares. So prices will be somewhat different. But I don’t think that affects the best move for you.

ANo. Go for the lower fees! And you might as well do it this year, unless there’s a chance you will need access to the non-KiwiSaver money before your wife turns 65.

If the risk levels of the two investments are different — perhaps the managed fund money is all in shares and the KiwiSaver fund is at lower risk — you could move the money in two or three lots. That would reduce the effect of what could be bad market timing, as explained in the above Q&A.