On the surface this is an unpalatable solution for those who dream of accumulating assets, but often that dream turns into a nightmare, so it pays to think all options through if loan repayments become difficult. There are many other solutions, but sale of assets is one of the most liberating and effective.
Thousands of Australian have been lured into debt by low interest rates and easy credit. Most have done their calculations and convinced themselves that they can buy investment properties at cheap interest rates on “interest only “ loans, earn a small profit or a tax deductible loss from renting it out then sell it for a capital gain taxed at only 15% or 20%. It is just easy tax avoidance which our politicians generously offer.
Negative Gearing
But is it a gift to voters or to the moneylenders who bankroll the political parties? Given that the loss caused by the interest means that $1 must be lost to save tax of 37 cents ( if total taxable income is around $100,000), the investor is out of pocket by 63 cents in every dollar spent on interest or maintenance during the period of the loan. The capital gain is suspect because property values go up and down and contain an inflation factor which is no gain at all. If the capital gain is taxed at 15 % the person enjoys a net after-tax gain of 85% compared to the loss on interest paid of 63%. Thus they have achieved a gain of 22% (85 less 63) if the interest paid equals the capital gain. It is a sum that few bother to do.
However many loans have passed their initial “interest only “ period now and that can cause problems to those borrowers for whom the loan was never really affordable. I have always considered an “interest only” loan as being a “claytons loan”, that is to say, a loan for someone who cannot afford to borrow service and repay that amount. It looks so easy when one focuses on the interest. It is quite hard when you consider that the property may not be easy to convert back into cash, but the debt must be repaid in cash on time. Holding assets purchased with loans and bleeding cash is a common financial sickness faced by many borrowers the world over.
When to quit
The collapse in real estate prices that usually follows most booms exacerbates the financial crisis they face. For many it is seriously worthwhile considering the sale of all or some of the assets they hold on borrowed money. My philosophy on almost everything is that it is worth giving it a go, but then the things that do not work should be quit as soon as convenient. If the bank is issuing default notices, the property is costing more to hold than is covered by rent or the property market looks oversupplied (which often foretells a crash), the borrower might well do some sums to work out the plusses or minuses of selling property. In some cases property investors may be able to sell enough of their real estate at good enough prices to clear their debt and have some assets left debt-free. That is a great situation to be in. I know that “fortune favours the brave” but for each of those brave ones who make a fortune there are a good number who lose everything, so I see exiting debt as frequently being a good option.
The issue with holding investment properties on debt is that the holder is speculating on a capital gain at low tax rates. The real benefit from negative gearing frequently flows to the moneylenders, not the investors who rarely take into account inflation, discounted cash flow or the real tax benefits they receive. The banker makes a killing because lenders just earn the interest and often send their profits to a tax haven so they don’t pay tax on the gain at all. If they foreclose they can stage a forced sale and invite friends and associates to buy a good property cheap.
Good Debt
Debt can help individuals, businesses and farmers to acquire properties they could not otherwise acquire, so in that sense it is good. It can destroy them through the accumulation of unpaid interest on which penalty interest rates are charged and through changed financial or economic circumstances. Good debt is well thought out, to purchase long term assets with an affordable repayment plan drawn up before the documents are signed. Sensible borrowers will make significant changes to reduce their spending patterns in order to clear debt early. Debt seems benign, but a change in the economy, the law, demand or health can change the situation almost overnight. Like a surfer on a wave, it can work well if the balance is kept right, but go seriously wrong with the slightest miscalculation.
That is why I converted my Chartered Accountancy practice into a Bank Borrowing consultancy. I saw the destruction and heartbreak that followed bank de-regulation and set out to even the scales and give borrowers enough support to not be taken down by ruthless lenders. The Biblical proverb “A borrower becomes the lender’s slave” is just as accurate today as when it was written BUT well thought out and well managed, the bank can become the borrower’s slave instead.