• Wiehann de Klerk

Debt Is Not Always Bad

Updated: Oct 29, 2018

Debt is not always bad; sometimes it opens up great pathways for investment.

Imagine buying this house with none of your own money.

Debt is something powerful when used properly. Something that a very small proportion of the world population is aware of is how to use it. I have tried having conversations with others about good debt numerous times, most of the time without avail. It's just not conventional wisdom. Bad debt, however, is something that a large proportion of the population is aware of and engaged in. Say an 18-year old called John just purchased a house. At first, you might be jealous that he was able to do this at such a young age. However, don't be fooled. Unless the 18-year-old has rich parents that bought the house for him, he probably took out a 90% Loan to Value (LTV) loan to purchase that property. In other words, 90% of the house is financed by debt and 10%, his own capital. Now let's say that he tries to be smart and rent it out. Assuming he did no real estate calculations, he probably purchased a negative cash flowing property, meaning, he rents it out for less than the costs of the property; such as mortgage repayments, maintenance costs, insurance, council rates, and other expenses. Let's say that John purchased the property for $200,000, rents it out for $1,000 per month with expenses adding up to $1,400 per month. The end result is a property that costs $1,400 - $1,000 = $400 per month just to own it. If you live in Australia, you will, with tax advantages, get $400 x 30% = $120 back, therefore, best case scenario is losing $400 - $120 = $280 per month. You know you're in trouble when the best case scenario is losing money. I have met a lot of people that do this. It is, unfortunately, a popular "investment" strategy. It's just what people do when they lack knowledge. The lack of knowledge identifies bad debt as good debt. This example is indeed an example of bad debt - there is nothing inherently good about losing money on a monthly basis. For more info about negative cash flowing properties (negative gearing), read the blog, Financial Enslavement. If John had financial intelligence, he would not have purchased this property. Good investors use debt, but they use it in a manner where it benefits them. They accumulate good debt - debt that provides them with benefits. Good debt occurs when debt is used, as a means of finance, to purchase an investment that provides a return, greater than the repayments on the debt used to finance it. Good debt is debt that is paid by the investment, not the investor because, if the investor had to pay for the debt, then the debt probably isn't good. For example, if John purchased a property with good debt, he would have purchased a property that costs tenants $1,400 per month and costs him $1,000 per month. In this instance, the property provides a cash flow of $400 per month or $4800 per year.

In Australia, however, bad debt is the norm. This is not always the fault of the borrower, yes, the borrower lacks knowledge, but, banks have, for a long time, provided easy money with casual lending criteria. The Reserve Bank of Australia (RBA) has also made things easier for borrowers, by continuously reducing interest rates. In the graph below, we can see that the official cash rate in 1991 was 15%, and now, in 2018, it's 1.5%. The cash rate is the interest rate that banks pay or charge when borrowing from or lending to other banks on an overnight basis. The RBA has, through its monetary policies, reduced official interest rates to record-breaking levels, over a course of 28 years.

This cannot be debated, yet some try to - the continuation of low interest rates has been and will continue to be a prime stimulant of large imbalances in the Australian economy, in particular, its relativity to growing household and foreign debt levels, and falling household and national savings. Low interest rates create demand as it encourages additional investment spending and/or further borrowing. Low interest rates give an economy a boost in times where there is slow economic growth. RBA Governor, Dr. Philip Lowe, has recently stated his disbelief in the cash rate reaching 2.5 percent anytime soon, but perhaps by 2021. This means that interest rates will remain low over the coming years. Low interest rates reduce incentives to save, and reduces the cost of borrowing, overall resulting in increased asset prices. In other words, assets such as housing in Australia is not based on wage growth, but debt. The lowering of interest rates over 28 years has caused a demand for debt to occur. A demand for debt has resulted in artificial increases in the value of assets in Australia. Smart investors understand that it is not the interest rate which is important, instead, it is the effect of the interest rate on the mortgage repayment. Obviously, when interest rates are higher, mortgage repayments are higher. However, if the rent from the investment property is high enough, to service all the expenses incurred in holding the property, including high interest mortgage repayments, then it could be a good investment. In 1990, when interest rates were above 15%, it was still possible to invest well - higher interest rates simply meant that investors had to ensure that the rent payable was high enough to cover all incurred expenses. To the contrary, the average investors are so concerned about interest rates, they forget about all the other important calculations needed before making an investment decision, such as Cash-On-Cash return and Return On Investment (ROI) just to name a few. For more on investment formulas, check this blog. When interest rates are low, they buy houses and when interest rates are high, they don't. The stupidity of this thought process is not worth any further comments.

Housing Prices and Household Debt

Ratio to household income*

Sources: ABS; APM; ARPA; CoreLogic; RBA.

The graph above shows the ratios of nationwide housing prices and household debt to household income. If people only purchased houses with cash when they had the money to actually afford properties, houses prices will have grown alongside wages.

Housing Prices and Median Income

Index: 1970 = 100

Notes: Data for 1970 to 2010 is from Yates (2011). Data from 2010 is six-monthly growth in the residential property price index from ABS (2017c), deflated by the CPI. Earnings data is full-time ordinary time earnings from ABS (2017d), deflated by CPI. Sources: Yates (2011), ABS (2017c) and ABS (2017d).

But instead, debt has fueled the increase in property prices over the past 28 years. The biggest mistake that a lot of people make, is to believe that house prices will continue to rise. This belief causes people to convince themselves to purchase an asset despite their inherent inability to afford it. A believe that an asset will rise in value makes the use of debt to acquire it a worthwhile activity. This belief is so high in Australia - it's like the whole nation has been living on a fantasy island. Banks and individuals have all been taking this drug, this hope in high future prices. Most people will say, "wow, real estate is the way to go, it's a great investment, look at the growth" but smart people will ask a question, "why are the house prices so high in Australia, relative to other countries?" Look at the graph below for example. Good investors will look at this and ask, why?

Housing Prices: Australia and USA

Index: March 2002 = 100

Source: ABS 6416.0, S&P Case-Shiller 20-City Home Price Index.

Smart investors ask why, but dumb investors don't and simply do what everybody else does. When it comes to investment, the more questions we ask, the more assured we become of the quality of the investment. I recently purchased an artwork valued at $5000. Prior to making the purchase, I researched for over 15 hours. I called a number of galleries, emailed a few until I found the phone number of the artist. I did this to avoid paying gallery fees. All the research indicated an expected growth in the value of the artwork of 5% per year for five years. Right now, at the time of writing this blog, the value of the artwork is $5500. Investors spend time, do calculations, make calls, and when everything ticks the boxes, they negotiate a good deal (I paid $3000 for the artwork). They continuously ask questions. Also, investors do it fast because good deals don't last forever. I did the 15 hours of research in less than two days.

Australian House Prices and Household Debt

Source: Bloomberg, Bank of International Settlements

However, in Australia, everyone has been saying that real estate is a good investment, and, saying this means that debt is a good investment. I'm hoping that you agree that debt is not a good investment. The above graph portrays this attitude that Australians have regarding debt - Australians are addicted to debt. Its all well and good that real estate prices have risen, but what happens when a large majority of borrowers foreclose on properties? Real estate prices will plummet. Currently, there are $1.7 Trillion dollars held by the banks for owner occupiers and investors. In total, this adds up to 65% of the total lending of the banks. Banks have been issuing new loans against capital which is unrealized (equity), increasing the Australian mortgage market substantially, and, as a result, created this $1.7 Trillion debt bubble or as the report, "The Big Rort" warns, the $1.7 Trillion "piss in a fancy bottle scam."

Currently, the simple and common practice is this: Banks look at the LTV Ratio which is a lending risk assessment that financial institutions examine before approving a loan. The loan to value ratio (LVR) is calculated by dividing the value of the loan by the purchase price of the property. For example, a $500,000 property paid for with a $100,000 deposit and a $400,000 loan = a LTV of $500,000 / $400,000 = 80%. High LTV ratios are higher risks for lenders and, therefore, an approved mortgage costs the borrower more. The borrower may also be required to purchase mortgage insurance to offset the risks (usually if the LTV ratio is above 80%). Then, financial institutions look at the ability (income) of the borrower to service the loan. This is a simple calculation and is common practice, however, in Australia, lenders have been using a more complicated method called Combined Loan To Value (CLTV) ratio. Essentially, a borrower can use the equity in a house they currently own as a deposit to buy another house despite the inherent value or lack thereof in the new property being purchased. "The use of unrealized capital gain (equity) of one property to secure financing to purchase another property in Australia is extreme." This approach is a substitute for a cash deposit. The problem with this is the fact that it is a “classic mortgage Ponzi finance model." The model is only profitable when housing prices continue to rise, forever. Australia has a household debt level only surpassed by one other country, Switzerland, according to the Bank for International Settlements. "This Ponzi finance model" is a result of the false belief that real estate prices will rise forever. Such a model makes it very easy for anyone to continue raking up debt, up to their eyeballs. Here is an example of how CLTV works: say, that an individual has seven properties, in other words, seven mortgages. The total sum of all these loans (mortgages) is equal to $950,000. The appraised value of all these properties is equal to $1,200,000. Therefore, the sum of the loans ($950,000) divided by the appraised value ($1,200,000) is equal to a CLTV of 79.2%. This means that the individual has 20.8% x $1,200,000 = $250,000 of equity in the portfolio. This "ponzi finance model" allows the financial institutions to report cross-collateral security (equity) of properties against the total sum of loans for the purchasing of another property. Investors are able to accumulate properties despite their income level and the high property prices in the market.

CLTV provides investors with the opportunity to use debt to acquire more debt. Investors use the equity in a house (after the house has risen in value, mainly due to Australia's addiction to debt) as a deposit to acquire more debt, and so, the debt cycle continues. This has caused a major problem in the market, with amateurs buying up properties in large numbers. They don't do calculations on the properties they purchase. To the contrary, good investors do and it all starts by asking, "does this property I plan on buying have the ability to service the debt which I plan on accumulating?" Its a very simple question, and this question is what distinguishes good debt from bad debt. Bad debt arises from the misleading belief that real estate prices will continue to rise. Good debt arises from the understanding that an asset is only an asset when it provides a return higher than the cost of the loan needed to acquire it and the costs of maintaining the property. Smart investors love CLTV, despite how the widespread use of it has bubbled up the real estate market. The reason they love it is because they know how to use it for their benefit. Let's look at the top example - assume that the individual purchased properties that provide an average return of $10,000 per year, after deducting the annual expenses (mortgage repayments, taxes, maintenance) from the Yearly Gross Rent (YGR) of the properties, resulting in a total return (or call it salary if you like) of $10,000 x seven properties = $70,000 per year. If then, the investor uses CLTV to purchase another positively geared property, the investor is using good debt. The investor will be using the equity in properties that are currently serviced by the rents they generate, to acquire debt, in order to obtain another rent-generating property. Assuming the investor buys a positively geared property using the equity in his/her other properties, I would say, "well done." However, in the market, there are mainly bad "investors" who have been using bad debt due to their belief in misleading statements that real estate prices will continue to rise. If real estate prices continue to rise, real estate prices will be in the billions per house. Nothing rises forever. For more on positive gearing, check out the Financial Enslavement blog here.

"An investment property must have the ability to service the debt accumulated to acquire it; if it doesn't have this ability, it's not an investment. "

The other problem in the market is interest-only loans. The problem with interest-only loans depends on the ability of an investor to calculate the return on an investment. When the return on an investment is very low and the mortgage is interest-only, the investor can have a problem. When the return is extremely high and the mortgage is interest-only, the investor will probably be okay. The issuer of a loan, for example, a bank, has the right to change the loan terms as they please, unless it is a fixed interest or interest-only loan, and even then, it is only fixed for a period of time, usually 5-10 years. Consequently, what happens when the issuer of the loan decides to change the terms of the loan from interest-only to principal and interest? Well, the monthly mortgage repayment can easily increase by over 50%. Anyone that has an interest-only loan runs the risk of being a casualty to the bank, who, in the future, may decide to call in interest-only loans, something banks do just before a property crash. Despite this, an investor may be okay with mortgage repayments increasing by 50% if their investment provides them with a very high return. Again, investors need to do calculations before purchasing a property. Interest-only loans are only a problem when the success of the investment is dependent upon the misleading belief of ever-rising real estate prices. In the Australian market, banks have started calling in interest-only loans. And, in specific cases in Melbourne and Sydney, where house prices have fallen, borrowers struggle to service the principal when the interest-only period expires or they were unable to roll over the interest-only period. Recently, The Reserve Bank of Australia has estimated that a total of $360 billion worth of interest-only loans will roll over to principal plus interest over the next three years. To give you an idea, for the average borrower, repayments can rise by $7,000 per year or even worse - recently, in ABC news, a story of a farmer called Hugh Mackey was told: He had to pay an extra $30,000 per year, separate to the rental income of his two investment properties in Blackwater, not to default on his two loans. This is a huge issue: A investment should never be dependent on factors within a loan and, if an investment does depend on a factor such as interest rates, this should be included in the initial calculation as an element of risk, a what-if scenario. If an investor is not aware of the implications of a change in interest rates, then the investor has taken on bad debt, and may not even be worthy of being called an investor. Factors such as rent reductions, property crashes, interest rate changes, and government policies need to be included in investment calculations as risk factors. Investors need to, at least, be aware of the implications of market changes. What happens to simple homeowners who purchased their own home with an interest-only loan when it changes to principal and interest loans? Well, to meet either higher rate costs or a loan change to principal and interest, households will need to draw down on any existing savings they have, in turn, eroding further any financial buffer they may have had. It probably won't be much of a buffer, according to the RBA - 30-40% of households are only one month ahead of their scheduled mortgage repayments - many borrowers have only small buffers if things go wrong. In addition, according to Morgan Stanley, "Respondents to the 2017 AlphaWise survey had extremely small income buffers, with around 40% stating that they did not save over the past year."

Mortgage Repayment Buffers

Share of loans by number

* 90+ days in arrears. Source: RBA.

The below graph shows us again, the real picture. Unfortunately, I couldn't find a more recent graph as the RBA have changed this graph with a comparison of gross debt and house prices which inherently displays another story - I wonder why.

Household finances*

% of household disposable income

*Disposable income is after tax and before the deduction of interest payments. **Excludes unincorporated enterprises. Sources: ABS; RBA.

We can see that debt has risen substantially in Australia, but what is more important is the serviceability of the debt, rather than the size of it. The top graph shows that, despite the increase in debt over the past 28 years, the interest payable on the debt is lower than it was 14 years ago. One thing is certain - many households are not able to absorb interest rate surges and/or changes to their mortgages from interest-only to principal and interest. Another indicator of serviceability of debt in any nation is the Household Debt Service Ratio (DSR) - the ratio of household debt payments to disposable income. .

Household Debt Service Ratio (DSR)

Source: Bank for International Settlements (BIS)

According to the BIS, the DSR is considered “a reliable early warning indicator for systemic banking crises," whereby “a high DSR has a strong negative impact on consumption and investment." In comparison to other nations, Australia's DSR is the highest, indicating that a large proportion of disposable income in Australia is used for the purposes of servicing debt. Anyone that does any form of legitimate and objective assessment of the Australian market can come to only one conclusion, and that is a deep asset bubble of immense proportions. A long history of devotion and commitment to homeownership and negative gearing has resulted in Australians structuring and adjusting their finances and budgets around the accumulation of property rather than the strengthening of prosperity. The total dwelling stock to GDP was very high between 1960 and 1990, sitting on average, around 150%, however, this is nothing in comparison to the climb that followed thereafter, up to 360%, today (see below graph).

Value of Housing Stock to GDP

Sources: RBA; ABS; Australian Treasury

In addition, the ratio of the overwhelming amount of debt (mainly mortgages) to disposable income is the second highest in the world, at 190.1%, according to the RBA. Not to mention the median house price to median income ratios across Australia, ranging from 12x in Sydney to an apparently cheap, yet, inherently unaffordable 6x in smaller cities like Adelaide. Every indicator points to one word - unaffordable. And, when unaffordability is made affordable with easy loans, low interest rates, and interest-only loans, greater bubbles emerge and the average investors rake up the debt. To our unfortunate demise, Australia politics made it worse, moving the nation from flourishing vibrant resources and manufacturing industries, over twenty years to housing bubble realities. Since 1991, Australia has gone downhill. To make matters even worse, more than half the $1.7 Trillion dollars of loans held by the banks for owner occupiers and investors that underpins Australian property is borrowed from offshore. Basically, there is a high probability that the money you borrowed initially came from overseas. Due to our deficit account balance in Australia (borrowing more from trading partners than lending), demand for our local goods and currency has fallen and as a result, our currency has deflated and land prices have inflated, overall, negatively impacting our competitiveness as a nation, and moving manufacturing offshore. In the 1970s, our manufacturing output was 14%, in 2016, it hit a low 5%, the lowest according to the OECD. In 2016, the government at the time, the Liberal Party Coalition won with the "powerful" defense called "negative gearing," the stupidest thing I have ever heard of which resulted in the favoring of property as an asset class. I'm sad to say this, but Australia is not only infected by a property bubble but is fueled by the need to raise property prices artificially for the benefit of supremacy amongst others.

"A long history of devotion and commitment to homeownership and negative gearing has resulted in Australians structuring and adjusting their finances and budgets around the accumulation of property rather than the strengthening of prosperity."

Warren Buffet once said, “Only when the tide goes out do you discover who’s been swimming naked.” There are a lot of people out there with extravagant debt obligations, who are living life like everything is perfect. The tide is in, everything is in abundance - people are believing that they will always have a job to meet obligations. But, what happens if the tide goes out? What happens when they lose their job, or the banks raise interest rates, or call in all the interest-only loans or even worse, the inevitable property market crash occurs? When the tide is in, people might be able to get away with having so much debt, but not when the tide goes out. In the pre GFC period, American household debt to income was 138% according to OECD. If America was in strive at this level, what about Australia? Even if we considered the legitimacy of the net household debt instead of household debt (household debt less deposits) claim, it's still close to the mark of 138% faced by America. The saying, “She’ll be right” cannot be the viewpoint when it comes to debt obligations. This saying has been a hallmark in the Australian culture for many years, but, I believe it is time for individuals and households to choose appropriately when this term is used, and avoid using it when it comes to financial liberty, prosperity, and investment. It won’t be all right unless we choose to make it all right. Just because it is possible to become indebted for the purposes of acquisition does not mean that it should be done. The question of whether it should be done depends on the calculations completed prior to the purchase. The use of the correct calculations will depict the quality of the investment and whether the debt used to invest is "good" or "bad." There is only one time when debt is good and that is when someone else, or something else services it, otherwise the debt enslaves the borrower. In a debt-addicted world like Australia, it is safe to say that at least 30% of the population are slaves to the slave drivers, namely the banks.

I encourage you to ask yourself, what bad debt you have and what you can do to embrace good debt in your life.

Disclaimer: This blog provides you with general advice, not personal advice. That means that I did not take into account your personal objectives, financial situations or needs, even if they are known. Accordingly, this information may not be appropriate for you. I may provide general advice regarding the economy, monetary policy, and risk management techniques, but this is only general advice. You should obtain professional advice and ensure you read and consider the appropriate offer and disclosure document before acting upon any general advice provided.

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