Appropriate debt management is imperative for all wealth accumulation strategies. It is easy, however, to go down the path of carrying excessive levels of debt and debt which is hindering your ability to achieve financial independence in the long term.
In our most recent episode of Making Cents of It All, we took a look at the 3 categories of debt; horrible, tolerable and productive debt, and how each should be managed and used to optimise your financial position. We spoke with Phil Ringuet from Vincents Lending Solutions, about his top tips for first home buyers, property investors and insights on borrowing strategies.
What is the role of a mortgage broker?
The role of a mortgage broker is to deliver you unconflicted advice and services following a review of the entire marketplace. This will mean the best outcome aligning; the right product, solution and perhaps price, which can be achieved for your unique circumstances and matched to your needs.
The client experience should provide not just a solution to your needs but also save you on time, energy and hopefully money.
Just remember there is a difference between your local bank and a mortgage broker. You banker is trying to provide you the best solutions available at that point in time, but they are limited to the products and services the bank currently has available.
Things to consider first…
The most important element of debt is to ensure it is fit for purpose! Meaning, is it serving you and not holding you back from progressing on your wealth creation journey.
The banks are looking to create a profile of you as a borrower as they want to gauge an understanding of your spending habits, what type of debt you have, how you manage those debts, how you will manage the new debt through cash flow (your capacity to service the debt), and even your ability to plan for the future.
Every loan application is very much about spending. Banks are trying to understand what your ‘living expenses’ look like because this will help them determine what may be your borrowing capacity. Banks need to establish very clearly what your cost of living is around; groceries, rent, recreation, utilities, transport, etc. They will look back anywhere up to 3 to 6 months on transactions with a focus on your ‘conduct’ or ‘spending habits’.
Particular circumstances which may limit your capacity to borrow include:
- Multiple credit cards;
- High credit card limits;
- Your use of pay day lender facilities;
- Multiple applications for debt; and
- Personal Loans.
The bank will want to understand what the various loan facilities you have are, what you are using them for and how appropriate they are given your financial position. With a full understanding of your financial circumstances your mortgage broker does have the ability to present your story and supporting information to the bank with the potential to “explain away” certain debt.
A good mortgage broker will develop a strategy with you to try and ‘clean house’ by making recommendation such as:
- Close or reduce credit cards and the associated limits; and
- Paying out unsecured liabilities (personal loans) or other obligations that may exist.
The purpose of this is to simplify the picture being presented to the banks which hopefully increases your capacity to borrow going forward.
So what exactly are these 3 sorts of debt?
Horrible debt relates to debt that is not serving a purpose, as we highlight earlier. More specifically this type of debt usually relates to consumer debt which is run up on; credit cards and with pay day lenders.
The banks are not shy in coming forward and offering us all credit cards as soon as we get our first job. Then as our incomes increase so do our credit card limits which can begin to fund unsustainable lifestyle inflation.
The impact to your borrowing capacity can be significant. For example, the banks can assess your credit cards for ‘serviceability purposes’ at 45 times the limit you have on each card, not the amount you currently have owing. Therefore a $15,000 limit is consider a $45,000 debt, which in turn reduces your potential borrowing capacity.
This all plays into what ability you have of serving the existing, and more importantly, the new debt you are wanting to take out from the bank. Strategies to consider may include; reduce limits, consolidating cards or even getting rid of them all together. For a personalised outcome it is best to speak to a mortgage broker to define a plan to achieve your desired borrowing outcome.
Tolerable Debt generally comes about through funding education expenses or purchasing a family home. Although not directly linked to income accretive purposes it can provide improved earning potential over the longer term and a lifestyle asset.
When looking specifically at home loan debt we need to focus on borrowing to what you can financially ‘afford’ and not what the banks tell you your borrowing ‘capacity’ may be. The current low interest rates and a previously favourable lending environment has encouraged many people to borrow beyond their means to purchase the home of their dreams. You need to consider your existing cashflow position to service the potential borrowings, but more importantly, what your future family income and expense position looks like. For those transitioning through significant life events such as starting a family or kids commencing school, these transitions can put significant pressure on the family budget. Not considering the impact of this can cause unnecessary financial stress and anxiety on you and/or your family. Additionally, this approach can also place limitations on your ability to fund your future financial independence goals.
Appropriate consideration of your current and future position as well as the implementation of an effective home loan reduction strategy, will provide greater financial security no matter what life throws at you.
Productive debt is debt used in gaining or producing assessable income or investing into asset which are for the purpose of long term wealth creation. The interest expenses associated with this debt can become tax deductible when the expense is incurred in gaining or producing your assessable income. This is generally associated to borrowing on investment properties, share portfolios or business loans, which in turn produce you cash flow in the form of either rental, dividend or business income.
Debt is not always a bad thing, when used in a productive way you can increase the exposure to a particular asset class. In time this can have a positive impact on your overall financial position and long term financial independence.
When considering borrowing to invest, your interest rate is not the only determining factor of a good vs. bad loan (this goes for all forms of debt). You must consider the various features of the loan, including; offset or redraw facilities and a banks understating of your particular industry or occupation. Additionally, it is pivotal that you or your adviser is thinking 2 or 3 steps ahead for future opportunities and the borrowing strategies you may desire, because unsuitable borrowing structures can be costly to unwind or limit your future borrowing capacity.
Key concept – fixed verse variable interest rate loans
- Variable rates give you freedom and flexibility.
- Fixed rates serve the purpose of providing the borrower certainty of repayments. This benefits those who have limited to no surplus cashflow within their individual budgets (currently no additional savings ability).
- By fixing your loan this removes the risk of a rise in interest rates and the repayments that come with that, but you also remove the potential for reductions in rates and lower borrowing costs should rates fall.
- Remember you can always have a combination of both fixed and variable.
Key concept – offset account verse redraw facilities
The decision of which option may work best for you comes down to ‘the purpose’.
- Should you be purchasing your ‘forever property’ with no intention of leaving? Then potentially the best approach may be to utilize a redraw facilities.
- If your strategy is to convert your home into an investment property down the line, then an offset account may benefit your position more.
The key here is thinking about whether the purpose of your borrowings today, will remain the same purpose in the future? Speaking with your adviser(s) will help with this decision, and ensure you can easily identify all forms of debt current held and in turn maximise the potential tax deductibility both now and into the future.
First home buyers – where to from here
Preparation is the key!
- Understand who you are as a borrower.
- What does your credit score look like?
- What’s your current debt position? Both secured and unsecured.
- Does your conduct look good? i.e. do you have a good history of paying debts off on time.
- What is the consistency of your income? How will you demonstrate to the bank how you earn income.
- Speak with an investment savvy mortgage broker about what your borrowing power currently may be, and what your borrowing capacity looks like given any potential changes in your future financial position.
- Your advisers will provide you confidence around your borrowing ability so you can get into the market and win. Narrow your focus to property within your capacity.
- Start the conversation with your advisers early, 3 to 6 months out from when you are thinking of purchasing. This will give you time to make any changes to your current position which may put you in a better financial position to achieve your goals.
Actionable tips – summary
If I am a first home buyer, what is one actionable tip I should execute on today?
Get a budget! Money Management is pivotal when it comes to borrowing.
I am looking to buy an investment property, what is one action tip I should execute on today?
Preparation is the key! Focus in on what type of investment you are looking to purchase, and understating what the real purpose of that investments is i.e. income verse capital growth
If I am a startup or in a growing business, what is one action tip I should execute on today?
Know your business and have a business plan! You need to be able to easily articular; what is your business, what is your product and/or service, who is your target market and what are your future plans.
An Important Message
While every effort has been made to provide valuable, useful information in this publication, this firm and any related suppliers or associated companies accept no responsibility or any form of liability from reliance upon or use of its contents. Any suggestions should be considered carefully within your own particular circumstances, as they are intended as general information only.