NZ Herald 24 July 2004

AThat expression “getting your equity to work hard for you” — often used by property sales people pushing rentals or people justifying their property investments — always makes me wonder.

You’re already getting quite a lot of mileage from that $200,000. For a start, you’re living in a $350,000 house but paying off a $150,000 mortgage, so more than half your accommodation is “free”.

You’ve also got security — which is particularly important with a young family. It’s difficult to imagine a scenario in which you could lose your home. Once you start “making the equity work harder”, that could change.

There’s added security, too, in knowing that in an emergency — perhaps in your extended family — you could probably raise more money quite easily. Or, if you or your wife decides to set up a business, you have access to funds. Once you’ve tied up your equity, you lose that.

Having said all that, it is possible to boost your wealth — considerably, if you are lucky — by borrowing and investing.

For that to work well, you need:

• An investment with a total return higher than your mortgage interest rate. And keep in mind that you benefit only by that difference. If your mortgage is 8 percent, and your investment return after fees and expenses is 9 percent, is it worth it?

  The only investment other than property that might give a high enough return is shares or a low-fee, low-tax share fund.

  Shares are the riskiest of the major asset types, and therefore tend to bring in the highest average returns.

• About 15 years, or preferably more, to play with. Over shorter periods, there’s too big a chance that the shares won’t outperform the mortgage.
• The personality to stick with the investment, and not panic and bail out if things go badly in the shorter term.

  Picture this: You borrowed $100,000 to buy shares that are now worth $40,000. Could you, and importantly also your spouse, cope?

• Other sources of income, through the whole 15-plus years, that you can use to make the mortgage payments.

  You need not only job security — or the strong likelihood of employment elsewhere if you lose your job — but also insurance for loss of income, disability or death.

  Dividend income will help with mortgage payments, but it won’t cover the lot. As many property investors have found, cash flow problems can be the killer.

So, is it for you? Maybe. You’re young enough and on good incomes. But only you two can judge your own attitudes and job security.

And don’t forget that with any high-return investment there are no promises.

Will the bank let you do it? Given your strong financial situation, it might lend you, say, $100,000. You can always ask.

If it says “No”, try other lenders or talk to a mortgage broker.

Or you could get a revolving credit mortgage, in which case the lender doesn’t know what you spend the borrowed money on.

By the way, the above list also applies to borrowing to invest in property — although because property is less volatile than shares, the time horizon might be 10 rather than 15 years.

AFirst a bit of background. Dividends on most NZ shares are fully or partly imputed. This gives dividend recipients credit for the tax the company has already paid on its profits.

People in the 33 per cent tax bracket (taxable income of $38,000 to $60,000) pay tax at the same rate as companies. So they pay no more tax on the profit when it comes to them as a dividend.

Those in the 39 per cent bracket pay 6 per cent extra tax. But for those in the lower tax brackets, the company has already paid too much on their behalf. So they get a tax credit that reduces tax on their other income.

The problem for some lower-bracket people, including you, is that you haven’t got enough other income to use up that credit. And under the law, you can’t turn the credit into a cash refund.

You CAN carry the credit forward to use in future years, but the situation is likely to be similar then.

What to do about it? I suggest you sell some shares and buy enough investment-grade corporate bonds so that the tax on the interest they pay roughly uses up your credits.

Swapping bonds for shares will lower your risk. Therefore, in normal circumstances, it will also lower your expected average return.

In your case, though, the bond interest will be tax-free, reducing the difference between the two returns.

In any case, in retirement it’s a good idea to have the savings you plan to spend in the next ten years or so in bonds. If you leave it in shares or property there’s too big a chance that, when you come to sell, the investment will be going through a low-price period.