Borrowing is not all bad — it depends why we borrow
Reserve Bank Governor Alan Bollard has been telling us off because we keep raising our mortgage debt. But, from the individual’s point of view, how bad is that? It depends on why we borrow.
New Zealanders’ mortgage debt rose a rapid 16 per cent in the year ending September.
To my knowledge, there hasn’t been any research on what we’re doing with the extra money. But the Reserve Bank of Australia has been checking out Aussies’ habits.
While it found that a small portion of the borrowed money went on consumer spending — flash TV sets, holidays and the like — most of the money went on either paying off other debt or buying assets.
Does that make the borrowing okay? Maybe. Let’s look at these three uses of borrowed money.
“Buying things has become a sign of success,” I heard someone say on the radio the other day. But if you haven’t got the cash to buy, is it worth looking wealthy at the price of actually becoming poorer?
If you make a habit of borrowing to spend, you repeatedly pay more than just the purchase price. You will end up with far less wealth than someone who saves before they buy.
Paying off other debt.
Unless you borrow from a friend or relative, almost all non-mortgage debt comes at a higher interest rate than a mortgage. That’s because a mortgage has the best security, your house.
Generally, then, it makes sense to add to your mortgage and use that money to pay off a credit card, hire purchase or other debt.
There’s a trap, though. You will be swapping short-term debt for a mortgage that might run for 20 or even 30 years.
That means that, over the years, you may end up paying more interest, not less.
Consider a $5,000 short-term loan at 20 per cent. If you pay it off in regular instalments over three years, you will pay about $1,650 in total interest.
But if, instead, you add the $5,000 to a 9 per cent mortgage and repay it over 25 years, you will pay $6,300 in interest — almost four times as much — simply because you have borrowed the money for so long.
The way to get around this is to pay the money off fast. If you added $5,000 to your 9 per cent mortgage but paid that off in three years, you would pay only about $700 in interest.
Borrowing to buy an asset that declines in value, such as a car, is not much wiser than borrowing for consumer spending.
However, if you borrow to buy an asset that usually increases in value, such as a rental property or a share fund investment, that is sometimes a good move.
It all depends on the annual return on the asset — which on a property is price growth plus rent minus rates, insurance and maintenance, and on a share fund is price growth plus dividends minus fees.
The rule is this: If the average annual return over the years is higher than the mortgage interest rate, you come out ahead.
If not, you would have been better off simply investing your deposit without borrowing. Having the loan has cost you more than it has gained for you.
This situation could apply to rental property owners in the next few years.
Lately, their returns have easily exceeded mortgage rates. But house prices don’t have to actually fall to change that. Even if price rises merely slow right down, landlords could find that having a mortgaged investment does them more harm than good.
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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.