How to make the most of cheap debt before interest rates rise

Aussies are no strangers to debt.

Our household debt-to-income ratio is the fourth highest globally. Three out of four households have some form of debt, and close to one in three of us owes three times our annual income.

Is this a problem? Yes, and no.

Used wisely, debt can be a tool to build wealth. The trick lies in recognising how debt can work in your favour while also knowing the potential for it to leave you financially skewered.

Despite today's wafer-thin interest rates, debt doesn't have a great reputation. Many of us still see it as something to avoid.

A survey from the Consumer Action Law Centre found being debt free currently ranks as the top symbol of "success", above personal health, raising a happy family or having time to enjoy life.

Becoming debt free at some point is a worthwhile goal. But not all debt is "bad".

And as today's ultra-low interest rates won't be around forever, maybe now is the time to rethink the way we use debt.

Put lazy money to work

Over the past three decades the Reserve Bank of Australia's official cash rate has plunged from almost 18% to today's 0.1%. That's great news for borrowers but not so good for savers.

Reserve Bank data shows the average interest being earned on savings accounts is a miserly 0.05%. Locking away cash in a 12-month term deposit won't offer much benefit, pushing up the rate to an average of just 0.3%. The catch is that inflation is sitting at 1.1%. So, when the deposit matures in a year, the purchasing power of the money will have gone backwards by 0.8%. Hardly 
a recipe for growing wealth.

But low rates haven't stopped Australians stockpiling savings at levels not seen since the 1970s. In March 2021 alone, we shunted an extra $9 billion into savings accounts, bringing household savings nationally to $1.2 trillion. This has left banks awash with cash. As a guide, NAB's 2020 financial report showed it had $175 billion in customer deposits earning zero or near-zero interest.

With so much money on deposit, there's little incentive for banks to raise rates on savings accounts.

But there can be better ways to put spare cash to work even in today's low-rate world.

Making your money work harder doesn't have to mean taking on more risk - or more debt.

Paying extra off a home loan can generate significant savings on long-term interest. As our homes are a tax-free asset, for a high income earner the saving in paying down a mortgage with the average rate of 3.11% is the equivalent of earning a before-tax return of 5.7% on other investments, something that would involve taking on considerably more risk.

At the same time, Australians have $20 billion in credit card debt attracting interest. Amazingly, when the cash rate is near-zero, the average "standard" card rate is 19.94%, while on a "low-rate" card the average is 12.73%. Even with a low-rate card, using spare cash to pay off the balance can see you save more than 40 times the interest you'll earn on cash savings.

Mortgages tick the right box

Right now we could be in something of a sweet spot, where interest rates are ultra-low and asset markets are buoyant. It's not just a cue to rethink how we use savings; it can also be an opportunity to make debt work in your favour.

But not just any debt. A key step is to distinguish between good and bad debt.

"Good debt is used to acquire assets with long-term investment potential. Bad debt is debt you cannot afford to repay, or incurring excessive debt on discretionary spending," says Dennis Teale, acting head of local banking distribution at Bendigo and Adelaide Bank. He adds that bad debt is normally associated with "simple credit such as credit cards, personal loans or buy now, pay later arrangements".

Happily, the bulk of Australian household debt ticks the "good" box. As we've seen, the vast majority, 76%, comprises home loans. And there's no doubt plenty of homeowners have done very well 
out of bricks and mortar.

Since 2019, variable mortgage rates have dropped from over 3.75% to 3.11%, though, as the chart below shows, homeowners who've refinanced to a new loan have potentially scored even bigger rate cuts.

Over the same period, CoreLogic figures show that home values have climbed from a national median of $518,879 to $624,997 - a rise of 20%. That margin between interest rates and the growth in property values highlights just how "good" mortgage debt can be - as long as homeowners can comfortably handle the repayments. Nonetheless, there is scope for home loans to be bad debt, something home buyers need to be aware of in today's rising property market.

Mortgage Choice research found buyers have mixed views about the current market. Only two out of five are confident now is the right time to buy, while one in three is hesitant.

"On one hand, home loan interest rates are at historic lows, and this has pushed the financing cost of a home down to record lows," says Susan Mitchell, CEO of Mortgage Choice.

"At the same time, property values are surging, and this is likely to be driving significant FOMO [fear of missing out] activity among buyers who are concerned about being priced out of the market altogether if they don't act fast."

The downside of letting FOMO drive decisions is that it can lead to costly mistakes.

"Even with best intentions, a home loan intended as good debt may not end up as planned. Imagine purchasing a home only to find out expensive repairs are required, or a recent renovation was completed without local authority approval," cautions Bendigo and Adelaide Bank's Teale.

He advises buyers to take the time to be sure they're not getting a problem property.

"Don't be afraid to ask questions of the agent, and always use a registered building inspector to provide an independent report on the property. Your offer should be conditional on this being to your satisfaction."

A poor choice of property isn't the only risk of turning a home loan into bad debt. "When I think of 'bad' debt relating to home loans, it is more in terms of inappropriate drawing down on home equity to consolidate debt with items that are unlikely to carry future value," says Teale.

He cites the example of folding a car loan into a home loan. It's a process that can reduce total monthly debt repayments.

"[But] you will be repaying the debt over a term longer rather than the life of the vehicle." And that means a higher long-term interest cost.

Take it up a gear 

If you're happy to take on more risk, using debt to invest - a process known as gearing  - has the potential to supersize returns. It's something Australians are familiar with through property investing.

Gearing lets you buy a high-value asset using a small amount of your own capital, or diversify an existing portfolio in far less time than if you were to drip-feed your own cash into the market.

The icing on the cake is that when debt is used to fund investments, the loan interest can usually be claimed as a tax deduction.

Not surprisingly, the low cost of home loan finance coupled with skyrocketing property prices and a recovering rental market has seen investors flock to property. In March 2021, there was the biggest jump in loans to investors since July 2003.

"After a 20-year low, loans to investors increased for the tenth consecutive month, with the value of investment loans increasing by 12.7% in March 2021 and 54.3% for the year on the back of improved rental market conditions," says Adrian Kelly, president of the Real Estate Institute of Australia.

He says investors need to be just as cautious as home buyers, especially those buying in the burgeoning regional markets.

"Investors should be wary of investing in regions they do not understand. If the region is being 'promoted', do your own independent research. Exercise caution about claims of positive gearing (where rental income far outweighs the property costs) as high rentals are generally associated with areas of higher risk."

Get into the sharemarket

Gearing is not restricted to property investing, and there is a way to take advantage of today's record low rates without committing to a sizeable loan on a rental property.

Margin loans - a type of loan designed to invest in shares, managed funds and exchange traded funds (ETFs) - are experiencing a resurgence in demand, fuelled by a 56% rebound on the sharemarket over the past 12 months

A margin loan typically lets you borrow up to 70% of the market value of your selected securities.

These securities act as collateral for the loan. The lender provides a list of securities you can borrow against, while also specifying the percentage of each approved security's value that you can borrow, known as the loan to value ratio (LVR).

Margin loans tend to be interest-only. You don't usually have to make principal repayments each month. A distinguishing feature is that you don't have to borrow up to the maximum LVR specified by the lender. You can maintain a conservative LVR of, say, 40% of the value of your portfolio even though it may offer a maximum LVR of 70%. This is an important aspect for investors to bear in mind because the LVR is subject to share price movements, and keeping the LVR within the lender's limits can be challenging if markets collapse.

To see how margin loans work in practice, let's assume Davina (not her real name) combines $40,000 of her own money with a margin loan of $60,000 to buy $100,000 worth of shares - an LVR of 60%. Davina is entitled to 100% of the dividends and capital gains on her $100,000 portfolio even though she has only chipped in $40,000 of her own money. In this way, gearing can magnify Davina's returns.

The downside of gearing is that it can also magnify losses. If Davina's shares drop in value by 5%, her portfolio will be worth $95,000 (LVR of 63.1%). But she still has to pay interest on a $60,000 loan.

A potentially bigger issue is the prospect of a margin call if the market dips further. If the sharemarket tanks and Davina's shares fall by an additional 25%, her portfolio will be worth $71,250 and the LVR will be pushed up to 84.2%, well above the 70% limit. At that point, Davina can expect a "margin call" - literally a phone call from the lender asking her to bring the LVR back down to at least 70%.

She could do this in one of three ways:   
• Tipping cash into the loan to reduce the balance; 
• Selling some of the securities (not ideal in a down market); or
• Offering other shares as additional loan security.

In practice, lenders generally allow a 10% buffer to absorb short-term volatility in share prices.

Nonetheless, the reality of a margin call was driven home during the GFC of 2008-09. Australians piled into margin loans in the late 2000s, spurred on by a rapidly rising sharemarket. By late 2007, margin loan debt totalled $38 billion.

That all changed in December 2008 when the sharemarket plunged 30%, leading to a flurry of 
margin calls. At one stage, lenders were making a whopping 10 margin calls a day per 1000 clients.

Back in favour

While the experience of 2008 saw plenty of investors back away from margin loans, it also resulted in sweeping industry changes.

New regulations around responsible lending came into effect in 2011, putting the onus on lenders to assess the suitability of a margin loan for each borrower.

These days, better regulation and low interest rates are driving fresh interest in margin loans.
Lily Elliott, head of Leveraged, Margin Lender of the Year in Money's 2020 and 2021 Consumer Finance Awards, says it is hearing from investors who are disappointed with their cash returns and looking to invest in shares or property.

"It's quite a unique situation right now. With low interest rates and positive market sentiment, customers are seeing the opportunities."

Younger generations in particular are taking advantage of gearing.

"For the year to date, 30% of new applications for margin loans have been from investors aged 18-35 and of these 30% are female, which is higher than normal," says Elliott.

She believes margin loans have the potential to be good debt, though with a few caveats.

"Margin lending may be one of the ways you can take advantage of the current growth environment to help build wealth or expand and diversify an existing portfolio. But investors need to go in with a full understanding of the risks and how to mitigate them."

She adds that any geared investment should be thoroughly researched. She cautions: "Don't let FOMO be your driver."

Cost versus returns

Elliott says the quality of the asset and its return determines whether a margin loan is a worthwhile debt to take on.

A margin lender's list of approved securities helps borrowers meet the quality test, but it's still essential to weigh up the cost of the loan versus likely returns.

As a guide, Leveraged's margin loans come with a variable rate starting at 6.45%, though rates fall as the loan size increases.

Investors can expect to pay as little as 3.99% for fixed-rate loans above $500,000 where the investor pays interest 12 months in advance.

Either way, the underlying investment, be it shares or ETFs, needs to earn at least this rate for borrowers to break even.

How to reduce the risk  

Fortunately, serious market downturns are infrequent. But as we saw in 2020, it's risk that can't be ruled out. So it pays to be prepared, and a number of strategies can reduce the risk of a margin call.

1. Opt for a lower LVR

Back in the days of the GFC, margin loans typically had an LVR of 55%. According to Elliott, LVRs these days are more conservative. Leveraged offers LVRs between 25% and 75%, though the average is around 35%, giving investors more of a safety net if markets fall. The benefit of starting with a low LVR was highlighted during last year's sharemarket rout.

The S&P/ASX 200 shed 37% of its value between mid-February and late March, but only around 15% of Leveraged's investors received a margin call.

2. Diversify your portfolio

The simple process of diversifying across shares and sectors, ETFs, international shares and unlisted managed funds can help to protect a geared portfolio against falls in any one market. It seems investors are taking exactly this approach, with Leveraged reporting a 40% rise in ETFs funded by margin loans.

3. Have an escape plan 

Asset markets are unpredictable, and Lily Elliott urges investors to be "well-prepared for cyclical changes [in asset markets] and have a clear plan of action should the market take a turn". That may include holding onto spare cash.

When the sharemarket plunged at the start of the pandemic, among those Leveraged borrowers who received a margin call, Elliott says a large proportion injected cash into their loan to reduce the balance rather than selling shares.

"Always leave room for fluctuations," she advises. "If you don't fully understand what you're doing, get quality advice."

With home loan rates dipping below 2%, existing homeowners may be tempted to use home equity to invest in shares and other listed securities rather than taking out a margin loan.

But as Elliott points out, "a margin loan is an interest-only line of credit specifically designed for investing in the sharemarket with built-in controls to monitor your position." As a specialist product, they can also have tax benefits.

In particular, with a fixed-rate loan investors can usually claim up to 12 months of prepaid interest in the current financial year. This hinges on having the cash on hand, but it can be a useful strategy if your income in the current year is likely to be higher than in the next. Prepaying loan interest may also entitle borrowers to a rate discount.

What lies ahead

Margin loans are not a tool for speculative trading. So it pays to commit to your geared portfolio for the long term. While it's impossible to accurately predict how any market will perform over long periods, there may be momentum for further capital growth in sharemarkets as we move through the pandemic.

Low rates and a flood of government stimulus are supporting the business community, which bodes well for Australian shares. Shane Oliver, chief economist at AMP Capital, believes supportive monetary policy and rising corporate earnings point to sharemarkets being higher by the end of the year. He expects the leading Australian share index, the S&P/ASX 200, to end 2021 at a record high of around 7200 (up from 7045 in late May).

But it may not be an unbroken uphill run.

"Shares remain are at risk of a short- term correction with possible triggers being the inflation scare and rising bond yields, coronavirus-related setbacks, US tax hikes and geopolitical risks," warns Oliver.

For property investors the outlook also appears to be broadly positive. Oliver expects prices to rise another 15% or so over the next 18 months, boosted by ultra-low mortgage rates. Westpac economists Bill Evans and Matthew Hassan are also tipping a 15% gain in home values for 2021, slowing to 5% in 2022.

However, property analyst CoreLogic is warning of the possibility of tighter credit policies being introduced, especially if regulatory authorities see a rise in higher-risk loans. It says when tighter controls have been introduced in the past, it has dampened market activity and the pace of capital gains.

Perhaps the chief factor that will shape the returns on investments funded by debt is the path of interest rates. The Reserve Bank has repeatedly flagged that it doesn't expect to increase the cash rate until inflation is 2%-3% (it's currently 1.1%). For this to occur, Australia needs to see solid growth in both employment and wages, something the RBA isn't expecting to happen before 2024.

But that's not a cue for complacency.

The economy is on a road to recovery, and as the Reserve Bank's deputy governor, Guy Debelle, cautioned, "the state of the economy is the key determinant of policy settings, not the calendar".

Already, we have seen Commonwealth Bank lift its four-year fixed home loan rates. It could be an early warning bell that Australia's recent run of historic low rates is coming to an end.

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