Attitudes to borrowing
We all know that many people have become very wealthy through the use of borrowing. These people are often lauded as brilliant entrepreneurs and we are encouraged to emulate their success. But the last couple of years have again starkly reminded us that borrowing also comes with considerable risk and, potentially, financial ruin.
Where does borrowing sit in a wealth management plan? There are many opinions:
- A client, who really does not need to borrow to achieve his family’s lifestyle objectives, views his personal financial affairs like a company chief financial officer, and feels he should always have permanent debt of at least 20% of his net worth;
- Personal financial adviser, Noel Whittaker, in his “Ask Noel” column in the “Money” section of the “Sydney Morning Herald” of 18 November 2009, in response to a question regarding paying off the mortage versus investing wrote:
“It is a great strategy to pay off your house as soon as possible but it’s also important to put as many assets under your control as you can when you are young. Therefore I’m quite happy for you to borrow for investment provided your job is secure …”;
- Implicit by his action, a Mosman investment banker who borrowed $7 million to buy a $10 million residence in 2007 probably thought the best idea is to borrow as much as you can get your hands on – he is now bankrupt; and
- The spectacularly failed financial planning firm, Storm Financial, and its wishful thinking clients, looked at borrowing (and investing) as the way to realise previously unachievable dreams. Unfortunately, it proved a nightmare.
While all these opinions have some elements of truth, they are far too general. And, as the investment banker and Storm clients now appreciate, may carry the risk of financial ruin. Each suffers from the lack of an appropriate framework to think about the role of borrowing in a personal wealth management plan.
How we think about borrowing
In most cases, borrowing is the mechanism to bring forward future cash flow to purchase lifestyle and/or investment assets. If it is a lifestyle item, like a house or a car, you are able to enjoy the benefits now, but at the expense of reduced future cash flow due to interest and loan repayments.
If it is for investing, it enables you to own the investment asset immediately, rather than when cashflow becomes available. Should the value of the asset rise you will be better off than had you delayed purchase until funds were available from saving. Of course, if values fall, you will be worse off by bringing forward the purchase.
For most people, their intention is to enter retirement without any debt outstanding. Therefore, they borrow on the expectation that their future cash flow will be sufficient to repay all borrowings. They generally do not want to be reliant on the sale of the item purchased – be it a lifestyle or investment asset – to repay debt.
To this extent, we consider borrowing for personal wealth management more like bankers think about financing a stand alone mining project with a finite life, rather than lending to a company with ongoing activities. You want to be comfortable that over your working life (just like a mine’s life) all debt can be repaid from cash flow, with a high level of certainty.
For this purpose, you need to have at least an implicit view of your projected surplus capital (i.e. total expected surplus cash flow to retirement). For example, our doctor in the article, “The ‘secret’ to wealth creation”, estimated his projected surplus capital at $3.125 million.
Given this, he may be comfortable borrowing $1.5 million now for investment purposes, confident that unless something goes badly wrong he will easily be able to repay the borrowing from future cash flow. As a fallback, proceeds from sale of the investments purchased (assuming they were not total “duds”) could be used to appease his bankers.
However, problems can arise when sale of the investments is the primary or only means of repayment. If expected future cash flow was never likely to be sufficient to repay the borrowings, then repayment is highly dependent on the value of the investments. If values fall below the amount borrowed, the borrower may have to sell other assets to satisfy lenders. Without sufficient other assets, bankruptcy is the likely outcome.
How much should you borrow?
In our view, you should not deliberately borrow more than your projected surplus capital. In fact, given the uncertainties associated with future cashflow, borrowings should be somewhat less than this amount.
Otherwise, you are at least partially relying on asset sales to eventually repay debt. This then becomes asset price speculation, rather than simply bringing forward realistic expectations of future cash flow. While it is a great strategy when asset prices are going up, as we have recently seen, it can wipe you out if asset prices fall.
Given our emphasis on expected future cash flow as the prime determinant of borrowing capacity, its calculation is the critical input to any decision regarding the place of borrowing in your wealth management plan.