Is it Time to Use the Equity in your Home to Build Wealth? – Guidance Financial Services

With interest rates starting to fall, is there an opportunity to utilise the equity in your home for investment purposes, and accelerate your wealth creation? It’s something we’re certainly evaluating with several of our clients, so I thought I’d share with you today our current thinking. 

Thanks for joining us on another financial autonomy episode. Let’s dive into this week’s edition, is now the time to use the equity in your home to build wealth? 

In thinking through this question, there are 4 key considerations. The first two have greater significance than the second two, but all have relevance. 

1. Risk Appetite 

Borrowing to invest is a mechanism for increasing risk across your balance sheet. Using the equity in your home to invest is something only someone with a high risk tolerance should contemplate. The investment you undertake has an unknown outcome. We expect it to increase in value over a 7-to-10-year period, but there are no guarantees. What is guaranteed though is that you will have to pay the bank back its money, along with interest over the journey. There is the potential that you have to exit the investment at a point in time where its value is less than the amount borrowed, in which case you will have to come up with the shortfall. It’s unpleasant to contemplate, but it would be imprudent not to consider what you would do in such a circumstance. 

It is far from essential to pursue a gearing strategy. Be honest with yourself, and if the risk doesn’t sit well with you, consider accumulating wealth via surplus cash flow instead, a perfectly viable and successful approach. 

2. Cost of Money 

The cost of money has a huge impact on the likely success of a geared investment portfolio. We know that on average a portfolio exposed to the ASX 200 index is likely to produce a return of around 8% per year, the US index perhaps closer to 10%. So, as a starting point, if we’re to entertain borrowing to invest, we really want the interest rate to be below those two expected earnings rates. 

Now, there is nuance here. The interest on the debt is tax deductible, the Australian shares might throw off some franking credits, and capital gains tax only applies to half the growth provided you’ve held the asset for more than a year. 

Nonetheless, when deciding whether to pursue a gearing strategy, it is important to consider the interest rate that you will have to pay. This can be where using the equity in your home is attractive in funding a gearing strategy, because the interest rate is lower than would be the case for an investment loan. Right now, we seem to be in a falling interest rate cycle, and that should be helpful in making a gearing strategy stack up. But bear in mind that this type of strategy is usually for a 7-to-10-year time frame. There may be several interest rate cycles across that period, quite likely including some rising cycles as well. Usually, rates are high when the economy is booming and the central bank is trying to slow things down, so typically, were interest rates to rise to the point where the strategy no longer stacked up, it’s likely you could exit successfully. In reverse in economically tough times, interest rates are usually cut, so there might be improved affordability during environments where your investments could be struggling. But that is never guaranteed. 

3. Security of income 

Using the equity in your home to establish an investment portfolio requires that repayments are made on the loan that you established. Whilst the investments may produce some income, the amount and frequency will not align with your loan repayment obligations. To make this strategy work, you need to have the surplus cash flow available to cover the loan, irrespective of what the investment portfolio produces. Your investment portfolio would ideally have a strong bias towards growth rather than income, and you would reinvest the income it generates, if at all possible, to help compound growth and enhance the likelihood the portfolio value will exceed the value of the debt, thus reducing your risk. 

All this points to the importance of having security of income. A particularly bad outcome for a geared investment strategy would be a situation where there is an economic slowdown, and simultaneously you are made redundant, at the same time that the stock market has fallen. A forced liquidation of the portfolio at this point in time is highly likely to produce a poor outcome for you. 

Given this potential, it’s important that if you are contemplating using the equity in your home to invest, you have confidence that your income is secure across the economic cycle. You need to be able to hold this investment through the inevitable challenging times. Over the investment time frame, you should expect to experience 2 to 3 years where the value of the portfolio declines. You need to be able to weather these periods. 

4. Investment time frame 

The final key consideration when contemplating using the equity in your home to invest, is your investment time frame. As I’ve mentioned a couple of times now, I would not recommend this strategy for someone unless they had at least a seven-year time frame and ideally a ten-year time frame. We know that investment markets go down roughly one in every four years, but we have no idea when those negative periods will occur. It’s also totally possible that you could have two negative years in a row if you were particularly unlucky. As mentioned earlier, irrespective of what the investment does, the bank will want its money back. To manage this risk, it is essential that the investment has a long time frame so that the inevitable down years can be comfortably offset by the far more frequent positive years. 

Borrowing to invest can certainly be a great way to accelerate your wealth creation, and using the equity in your home to do it can work particularly well as the borrowing costs are normally low relative to your alternatives. But it’s not a strategy for everyone, and it’s not a strategy that is suitable all the time. 

One final thing for you to consider is your goals. Goals come at the start of any discussion about investment strategies. Borrowing to invest increases risk as I’ve touched on. If your goals can be achieved without taking on this risk, then that’s what you should do. 

Until next time, bye for now.