Risky SMSF borrowing advice from real estate agents

The Institute of Chartered Accountants of Australia (ICAA) superannuation specialist, Liz Westover recently wrote of her alarm at some marketing material she received from a real estate agent promoting borrowing within a self managed superannuation fund (SMSF) to buy property.

Westover wrote: “I was surprised and somewhat alarmed that some of the information provided was technically wrong and misleading, particularly in relation to the tax measures.”

Remember that Real Estate agents are NOT licensed financial advice providers.

Real Estate agents are licensed facilitators of a real estate transaction.

And in the current property climate it seems that some will do whatever they can to get more transactions occurring.  Don’t allow yourself to be misled – get financial advice only from licensed financial advisers.

 
 

 

Margin call calculation

When you have a margin loan it is important to understand how much your portfolio value can fall before you receive a margin call. This article reveals the formula for calculating the percentage fall to trigger a margin call.

A margin call occurs when you no longer own enough of the investment to keep the lender confident they’ll get their money back. If you receive a margin call you are asked to either:

  • Add more security for the loan – this can be cash or other approved investments
  • Reduce the loan balance – either through cash or by selling some of the investment

Neither of those remedies can be particularly pleasant so when you have a margin loan it is important to understand how much your portfolio value can fall before you receive a margin call.

The formula for calculating the percentage fall to trigger a margin call is shown below:

LVR stands for Loan to Value Ratio. It is calculated based on the amount you owe (the loan) divided by the total value of the security (the investment). For example an $80,000 loan against a $100,000 investment has a LVR of 80%.

The abbreviation in the margin call formula are:

  • Base LVR% = maximum allowed LVR% based on the quality of the lodged security (the investments)
  • Current LVR% = your loan ÷ your current portfolio value
  • Buffer% = the allowed buffer before triggering a margin call

Generally lenders won’t call you as soon as your Current LVR hits the Base LVR. Since the investments often fluctuate in value daily they give you a bit of leeway – know as a buffer. Many lenders give you a buffer of 5% but some have a buffer up to 10%.

For example if your Base LVR is 75% and the lender’s buffer is 5% they will call you when your Current LVR hits 80%.

Below is an example calculation of how much your portfolio needs to fall to trigger a margin call. The parameters in the calculation are:

  • Base LVR% = 75%
  • Current LVR% = 50%
  • Buffer% = 5%

If you choose to gear conservatively (at 50%) against quality assets with an allowed LVR of 75% (base) then your portfolio value can fall 37.5% before you trigger a margin call. That has happened but it is rare, which should give you confidence to consider margin lending.

If you can’t be bothered doing the calculation the following table gives you some examples of the percentage fall required. Note the buffer in this table is 10%. (Source: Leveraged Equities.)

From the above table you can see that when your buffer is 10% rather than 5% in the earlier example then for a current LVR of 50% and base LVR of 75% then your portfolio can fall by 41% before a margin call is triggered.

Advanced Gearing Products

This sixth article in the series on accelerated wealth creation summarises some other products you may have heard help you get rich fast. For example you may have heard of options & warrants, internally geared funds and capital protected funds.

Leveraged products for pussycats and lions

As sure as the sun sets in the west there will always be new wealth creation products launched. Many are suitable for a certain niche, so the trick is to find out which products suit your niche of circumstances.

Today I’m going to cover three that I feel have a broad-ish appeal, namely:

  • Internally geared managed funds
  • Options and warrants
  • Capital protected funds

If you’re a bit of a pussycat who wants a piece of the leverage action then there’s something in this article for you. Kings of the gearing jungle, the lions who want even more leverage will also find some tasty morsels.

Internally Geared Managed Funds

In the last article I mentioned the use of margin loans to use other people’s money to invest using managed funds. Well, there are actually managed funds that borrow money to leverage the money contributed by their investors. So the fund itself is a geared managed fund.

Following are three ways to make use of these products:

  • If you only have a little bit to invest and can’t be bothered getting a margin loan then you can still gear your investments by investing in an internally geared managed fund.
  • Superannuation laws prohibit gearing. However the regulators have said that they are generally satisfied with people investing their superannuation in geared managed funds. So geared managed funds are a way to super-charge your super!
  • Margin lenders will actually allow you to gear into managed funds that are already internally geared. This is a strategy for the lions who like to leverage their leverage.

Options and Warrants

Originally options were created to manage the risk of physically owning something, and they are still used for doing so. For example they gave you the right, but not the obligation, to sell your physical asset at a set date in the future for a set price (perhaps the price you paid for it). So you could buy an option to protect you from losing lots of money if the price of the physical asset went down.

In essence warrants are the same as options. Practically warrants in Australia differ from options based on who issues them, and the terms under which they are issued. (I’m trying not to delve into the complexity of these products.)

Options and Warrants are known as “derivates” since their value derives from the value of a physical asset, such as a share in a company. Whilst they were originally created to manage risk financial folk realised they could make money trading the derivates without owning the physical asset. Because of the way derivates are priced any movement in the price of the physical asset is magnified in the price of the derivative, hence providing you with leverage.

Every week in the newspaper there are courses advertising the wealth creation wonder of derivatives like options and warrants. My personal view is that using them for leverage is a specialist field. If you want to do-it-yourself then you should invest lots of time and money learning. But then I’d say that’s a job as a professional trader, rather than an investment creating passive income.

On the flip side, options are a wonderful tool for managing risk, which leads me to the next product I will write about.

Capital protected funds

Capital protected funds have many different names, probably made up by marketing folk. So let’s focus on understanding the core of how they work. In essence a capital protected fund combines the features of the two previously discussed products: internal gearing and options.

In the marketing spiel for the product you will most often read a pledge that if you invest in the product until maturity (5 to 10 years), then they guarantee you will at least get your initial contribution back. (Albeit, it will have less buying power due to inflation.) If you want to sell before maturity then the guarantee usually is not valid.

How these products facilitate the guarantee is becoming more diverse and complex, making it hard to understand what you’re investing in at times. But one way is the use of options to give them the right to sell the assets at maturity for the same price they initially paid.

One upside of these products is that you get the opportunity to benefit from potentially higher returns from the internal gearing of the investments. The other upside is that you probably won’t lose your money (but you could be worse off in real terms.) The downside is that protection costs money – the guarantee costs you money. So whilst you can get higher returns, you will get less return than if you did not buy protection.

Pussycats may really like these products, once you can get your head around the detail of how they work, since they enable you to potentially get higher returns without that nasty thing that you fear – your money going negative.

Lions may also like these products since many lenders will allow you to borrow the entire amount, yes 100 percent, of your investment in the product. You will need to cover the interest each year. In that sense a lion may liken the cost of protection to the cost of lenders mortgage insurance when investing 100 percent in residential property.

Consider and Learn

As I wrap up this series on strategies and products for accelerating your wealth creation I would like to leave you with two over-arching thoughts.

Consider what is appropriate for you right now. Take into consideration your current circumstances and needs, plus your future goals, and also your level of interest in the nitty gritty detail that some of these strategies require.

Seek out greater knowledge about sexy wealth creation products you hear advertised – maybe with the outcome of eliminating them from your list. Or maybe they’ll be added to your “not right now” list which you use to focus your learning efforts. Continue learning because the knowledge will raise your awareness of the possibilities and also make you comfortable with implementing them.

Right now do something, not nothing; but do what is right for you right now. Plus continue learning to expand the horizon of what is right for you.

Margin Lending: An easy way to start gearing

This fifth article in the series on accelerated wealth creation introduces margin lending, which many may have heard of but not know how to use it to create wealth.

Margin Lending

Margin Lending is a term you may know but perhaps it feels a little bit foreign or even spooky. Perhaps you’re imagining it’s something different to gearing and home equity, which you’ve seen before. Or maybe you’ve heard that it is risky.

Well, if you’ve understood the gearing and home equity concepts discussed in the past few articles then be confident that you also understand margin lending.

That’s because margin lending IS gearing. The main difference to home equity gearing is the security for the loan. With margin lending the security for the loan is usually direct shares and managed funds. So really margin lending is a different name for essentially the same thing – gearing.

One difference is how much you can borrow against your security. For top quality shares and managed funds you can generally borrow up to 70 percent or even 75 percent of the value of the investments. The more speculative your investment the lower the gearing allowed.

Finding a margin loan is quite easy as many of Australia’s largest lenders also have margin lending products. In fact I know of at least one lender who offers a loan that will accept property, shares and managed funds as security, creating a very flexible loan.

Handy features of margin lending

One handy feature of margin lending is that you don’t need to already own a property or shares to start gearing. You just need a small amount of savings. So that makes it a very accessible way of accelerating your wealth creation.

And that leads to the second handy feature – you can start small. You can start some margin loans with as little as $1,000 in savings. The lender will then offer approximately $2,000 as a loan, enabling you to start with a $3,000 portfolio.

These two handy features mean that this is a very accessible strategy, even for people who have just started their first ever job. Read below for how younger people can use margin lending to buy their first home.

Things to be aware of with margin lending

With margin loans the most important distinction to understand is that of the “margin call”. In the interests of brevity I’ll just say that if a margin call occurs you are required to either repay part of the loan, or add more security to the loan. The purpose is to ensure that you have adequate security to keep the lender feeling comfortable.

From a theoretical perspective a margin call could happen with gearing for property investment. But you hear about them in relation to margin loans because the price of the loan security, shares and managed funds, is published on a daily basis.

Whilst over the long term you expect your investment to rise, in the short-term there may be a dip. During the dip you may experience a margin call.

Even if you have maximised your margin lending your investment needs to decrease by around 10 percent before a margin call. So it is not a show-stopping feature. Plus there are plenty of ways to minimise the likelihood of a margin call.

One other feature to be aware of is that the interest rate on margin loans is often a percentage point higher than a home equity loan. So if you have home equity you may like to consider using that first. Plus, with home equity there is less likelihood of a margin call. But on the flip side, if you sell your house you need to refinance the line of credit too.

Instalment gearing for your first home

Instalment gearing is a regular savings plan partnered with a margin loan. Each time you add some of your savings the lender adds some of their money.

You can start an instalment gearing plan with as little as $1,000 in savings and $100 per month contribution. The lender may then offer an initial $2,000 plus $200 per month.

When you are starting in the work force but not ready to buy your first home for 7 years or so, instalment gearing can be fantastic. Many young people I meet are concerned they will never save a deposit as fast as the property prices rise. Instalment gearing is a way to keep up and even fast-track the saving of your deposit.

Super charge your wealth creation

Now, you may be wondering if you can combine gearing with home equity and a margin loan. Well, yes you can and it is a way to super charge your wealth creation plus diversify your portfolio.

For example you could borrow $100,000 against your home and use that as the security for your margin loan. The margin lender may then offer you another $100,000. This gives you $200,000 to invest, none of which is your own. Plus, since your margin loan is only geared to 50 percent you have possibly given yourself a buffer against margin calls.

This strategy is called double gearing and is riskier than single gearing, as you may expect. So proceed with caution and wisdom before considering it.

Create wealth with your home

I hope that you had a wonderful Easter. This fourth article in the series on accelerated wealth creation discusses using the underutilised equity in your home to create wealth.

On reading the title of this newsletter some readers may have asked “hang on, I thought Matt said your home is not an investment asset. So how can I create wealth with my home?”  Well, your home is not the wealth but you can leverage the equity in your home to create wealth elsewhere.

Even if you don’t yet own your own home or have any equity in your home this is still valuable knowledge because one day you will have some equity. So it will be important for you to be prepared for how you can wisely use that equity to create wealth.

Home Equity

Equity is that part of something you own, not the bank. When you buy your first house you may start with a 5 percent or more deposit, and that is how much of your home that you own. That is your equity.

As you repay your home mortgage you own more of your house, and therefore your equity has grown. It is this equity that can potentially be your “underutilised equity” as discussed in the first article.

You can choose to use this equity to create wealth or to create immediate lifestyle.

Home equity funding your lifestyle

Our bank loves to send us suggestive letters about the many delightful things we could do if we went and borrowed more money from them against the equity in our home. So it is quite possible you are already aware of how to access your home equity.

In fact, most people have fully utilised the equity in their home to:

  • Upgrade to a newer, bigger, better located home
  • Fund their holidays
  • Upgrade their cars
  • Improve their current home with major renovations
  • Pay for children’s education

Do any of the above sound familiar?

They possibly do since the banks make it very easy for us through redraw facilities and lines of credit.

But when you use your home equity to fund your lifestyle the money still needs to be repaid, plus interest. So you could be living outside of your means – a champagne lifestyle on a beer budget. Living outside your means potentially sacrifices your future lifestyle rather than creating wealth that funds your future dreams.

Use home equity to create wealth

To get rich faster use your home equity to create wealth. You do this by borrowing against the equity and using the borrowed money to invest. This is called gearing, as discussed in the last article. Since you are borrowing money it is important that you invest in growth assets such as shares and property. That way you aim to earn more than you pay in loan interest.

This strategy helps you create wealth faster by enabling you to be investing even when you may have all of your income focussed on repaying the main part of your mortgage.

Many people think they need to have repaid their home fully before starting to invest. For people with a low tolerance of risk that may be appropriate. However, if you can manage the risk of gearing then using your home equity to invest will get you into wealth creation sooner. The sooner you get in, the longer you are in, and hopefully therefore the more you can earn.

How to access your home equity for investment

One of the most common ways to borrow against the equity in your home is to create a new line of credit loan that is secured against your home. So you will end up with your mortgage plus a separate line of credit.

A line of credit gives you flexibility to invest the amount wherever you like – the bank doesn’t really need to know. Plus, as you buy and sell investments you can withdraw from and repay the line of credit as you wish, much like a bank account.

Once you have established your line of credit it is important to obtain expert advice on the investments you will use. Expert advice is valuable in helping you achieve more return than you pay in loan interest.

Crank Up The Pace With Gearing

This third article in the series on accelerated wealth creation provides an overview of gearing as a wealth creation strategy. Gearing is a strategy that enables you to leverage your income and equity, which may currently be under utilised.

Gearing: You’ve heard of it, but what is it really?

As one attendee at the IPWEA conference noted a few weeks ago, it seems that everyone’s talking about gearing as the holy grail of wealth creation. So it is possible that you have heard of it. But based on questions I’m commonly asked it seems there is only partial understanding of gearing. So here is a quick overview.

Gearing is a term used in wealth creation for leveraging your money. If you’re not familiar with leverage then picture a “see saw”, that wonderful mainstay of children’s playgrounds. Using a “lever” is a way to get more output for the same or less input. Or, to say it another way, leverage helps you get more reward for less effort.

Gearing is using someone else’s money to generate more wealth for you. Usually someone else’s money is provided in the form of a loan from a bank. The security for the loan is often property, direct shares or managed funds.

How Gearing Works

Simplistically, this is how gearing works:

  • You start with some of your own money (e.g. $100,000)
  • The bank adds some of their money as a loan (e.g. another $100,000)
  • You invest the whole lot (e.g. $200,000)
  • Along the way you pay the bank interest on the loan
  • Presuming you’re a wise investor your annual investment return percentage is higher than the loan interest percentage
  • When you sell you repay the bank the amount you borrowed but keep all the investment returns for yourself
  • Your net wealth has grown a lot more than if you didn’t gear, so you are now wealthier.

The Good and the Bad of Gearing

The main advantage of gearing is that you get wealthier quicker. This presumes that your investments go well.

The main disadvantage results from the fact that the lever can go both ways; you can also get poorer quicker. That is the main risk you face for trying to use leverage to get more reward.

Other risks of gearing include:

  • Your investments go up but not as much as you paid in loan interest, meaning you are now not as wealthy as if you’d not geared.
  • You need to meet the regular loan repayments, so therefore need an alternate steady form of income (such as your salary).
  • Even though gearing is a long-term strategy in the short-term you can be asked to repay part of the loan if the lender gets nervous about a drop in your investment value.

On top of the above list of gearing risks you have all the other risks associated with investing. Gearing magnifies the consequences if the risk eventuates. (Your fingers could get burned quicker.)

Gearing Pre-requisites

Gearing should be used appropriately and with caution. Here are some pre-requisites before considering gearing as a strategy for you:

  • You need a very high tolerance of risk
  • You need to have time and patience. This strategy requires you to have at least a seven year horizon before needing the money; in fact at least ten years is best. This time horizon matches the average cycle of investment markets.
  • You should be able to afford to meet the loan repayments from your other income.
  • You are a wise investor or are willing to pay one (i.e. a professional expert)

Gearing Tips

  • Use growth oriented investments such as property and shares or managed funds that invest in those asset classes. These asset classes have a good likelihood of earning you more than you pay in loan interest.
  • Protect your financial situation from disaster that would result in you needing to access your geared portfolio earlier than planned.
  • The top priority for protecting your financial situation is protecting your income. This is two pronged: (1) Protect against injury or illness with income protection insurance; and (2) ensure your skills and knowledge make you very employable.
  • Ensure the rest of your long-term investments are also invested aggressively. It is counter-productive to have conservatively invested superannuation whilst gearing outside of superannuation.

Time to Crank Up the Gears

If you have under utilised equity and cashflow you can accelerate your wealth creation by cranking up with gearing, just like on your bicycle.

Next issue we’ll cover gearing your underutilised home equity and the following issue we’ll talk about margin lending. Margin lending includes a wonderful feature called “instalment gearing” that is a wonderful tool for underutilised income.