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Thoughts on paying down loans

Discussion in 'Finance & Banking' started by Mark Laszczuk, 9th Jul, 2008.

  1. Mark Laszczuk

    Mark Laszczuk Well-Known Member

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    I know this is going to be anathema to a lot of people here, but it's a topic I'm interested in exploring. I'm the kind of person that likes to pay down loans, whilst at the same time borrowing for investment. Basically the idea is to use spare cash to pay down a loan until it is fully paid out, whilst at the same time using equity to purchase further investments.

    I like the idea of fully owning the assets. I may not end up with zillions of dollars worth of assets over time, but I personally am more interested in attaining cashflow for lifestyle right now rather than attaining bragging rights about how much my assets are worth and having to deal with large amounts of debt when I'd much rather be chasing adventure.

    Now, I know full well that wise investors manage their loans and take calculated risks to ensure that they have a safety net (this is what I do myself, cause you know, I'm a very wise person). At the same time, I look to successful businessmen and observe how they run their businesses and try to emulate what they do. What I have found is that in a lot of cases, they actively pay down debt in order to reduce the risk. But at the same time, they also aren't afraid to use the power of leverage, so it's a balancing act.

    I know it takes an element of risk to be successful, but I also believe that the mantra of 'high returns means taking on more risk' is nonsense. I believe that the more one understands an investment strategy, the less risk they take and the higher the chances of attaining better returns. Warren Buffett is a great example of this - 20%+ compounding returns over several decades all with a strategy that reduces the risk as much as possible. His investment style, once understood, is quite conservative yet he has achieved returns that are better than anyone else in history has been able to achieve over a similar timeframe.

    This way of doing business - because let's face it, owning investments is a business whether you like to admit it or not - makes a lot of sense to me.

    The reason I've been thinking about this a lot lately is mostly due to what's happened with credit and a lot of businesses, particularly in the property sector really taking a battering because they can't afford to hold assets and not being able to refinance, therefore they have to sell assets and they can't even do that! So now they're in a lot of trouble, simply because they didn't look ahead during the good times. Basically comes down to poor money management. Makes you wonder how, if the pro's don't do it, how the plebs are going to cope.

    My own situation is ticking along very nicely, thank you very much and I'm very comfortable at this point in time, able to take advantage of opportunities as they arise and I believe it's all because I actively pay down debt. Now I know it's not everyone's cup of tea and it's only one of thousands of different strategies out there, but it works for me.

    Mark
     
  2. Smartypants

    Smartypants Well-Known Member

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    Also like the idea of reducing debt.

    On IP's, all loans are IO, but once they next reach that point of expiry (i.e, IO period), instead of refinancing again, I may let them convert to P&I. By that stage, I'd like to think that they will be cashflow positive, so not costing me to hold.

    Re shares/mgd funds, I've touted here before that I believe in reducing my margin loan (also have borrowings from LOC's). My reasoning may be a bit different though. Eventually, I want to (will be) be in the position of living off distributions (and rents) and I don't want to be paying interest at that stage, even if it means paying tax.
     
  3. Billv

    Billv Getting there

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    Mark

    I don't believe in paying down my loans.
    I believe in borrowing to the max and letting the magic of inflation doing it's trick.
    However, I think that paying down loans could be good for people who have difficulties saving money.

    Cheers
     
  4. crc_error

    crc_error The Rule of 72

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    Not sure if I should share what I do, as we all know you keep your own cards very close to your chest, however I do pay down my loans. I have a 100% offset which each week put a large part of my wage into as forced savings. then once it builds up, I will take some of it and buy up more assets.

    I'm not scared of debt, but I also believe in manageable debt and a cash buffer which should be growing every day.
     
  5. Alan

    Alan Well-Known Member

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    Hi Mark.

    I also like paying down debt, BUT using the 'balancing' analogy.........

    On one side of the see-saw there's me who likes paying down debt.......on the other side I have a wife and two daughters. For the time being I'm forgetting about paying anything down! :eek::D
     
  6. Billv

    Billv Getting there

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    share it share it :D
     
  7. Jacque

    Jacque Team InvestEd

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    Haha Alan!! I can relate- though with two daughters and a son who eat as much as hubby and I do, it's getting expensive!! Remember the good old days when a bowl of noodles or a vegemite sandwich kept them going for hours?! :D

    The only debt I'm interested in paying down at the moment is our new PPOR- the most essential one, naturally. However, if I didn't have any non-tax deductible debt, I'd be looking at reducing investment loans- have done in the past and will do again when the time is right.
     
  8. Waimate01

    Waimate01 Well-Known Member

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    Debt .... bad (but sometimes handy for very short periods)

    Net Worth .... good.

    Negative gearing .... loss making - bad.

    Positive gearing .... cash making - good.
     
  9. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    I think that's an over simplistic view of things.

    Debt used to buy anything other than investment assets = bad

    Negative gearing = bad only if you aren't making enough growth on average over time to more than cover the holding costs

    Net Worth = meaningless

    Equity = useful but can be difficult to buy food with

    Cashflow = good and important, but usually not very tax effective on its own
     
  10. Waimate01

    Waimate01 Well-Known Member

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    Gross worth = meaningless

    Net worth = reality

    If the music stops and you have to put all your pennies in a pile after liquidating your investments and paying down your debts, what you're left with is your Net worth. Net worth is the only real measure of your financial wealth. If you've got $5m worth of property and $5m worth of debt, and a $100k income and losses of $80k a year before you buy your daily bread, then guess how much you're worth -- nothing ! All you've got is a punting position; nothing more.
     
  11. Mark Laszczuk

    Mark Laszczuk Well-Known Member

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    I agree with Sim. For me personally net worth is meaningless. It doesn't buy me the freedom I desire. It's all very nice to go around thinking 'I'm worth $X' but for me, freedom is priceless and that's what I aim for. It's pointless being able to say you've got a whole bunch of assets if you have to work a crap job you hate to finance them. Cashflow buys me that freedom, so that's my focus.

    Mark
     
  12. Waimate01

    Waimate01 Well-Known Member

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    But chaps, if it's *Net* worth, you don't have to work like crap to finance them - they're paid for. That's the difference between gross worth and net worth. Gross, you may have to work like crap. Net, and they're all paid for, you're down the beach, and they're producing positive yield for you.

    Net worth of (say) $7m, no debt, earning (say) 5% fully franked means an effortless income of $350k per year with a bunch of the tax already paid.

    Gross worth of $7m but with net worth of only a cuppla hundred grand means you'd better keep your day job !
     
  13. Mark Laszczuk

    Mark Laszczuk Well-Known Member

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    You're right. I'm in that situation at the moment, paying down debt. But instead of focusing on net worth (as in 'If I have $X net worth I can achieve an income of $Y at Z%) I look at it as 'the more debt I pay down, the higher my passive income'. It's the same thought process, just different ways of thinking about it.

    Mark
     
  14. Young Gun

    Young Gun Guest

    if I have additional funds the way I managed my debt on my managed funds and Shares is as follows:

    I will pay down my debt when I believe the market is at a high.....

    and I will increase my capitial base/fund additional borrowings when the market(or underlying investment) is low.

    its a conservative strategy but will help you avoid margin calls and become positively geared sooner rather than later. It follows the buffett aproach of being fearful when others are greedy and being greedy when others are fearful.

    it stopped me having a margin call over the last 12 months, but it didn't stop me making a paper loss :) !
     
  15. ashwright

    ashwright Well-Known Member

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    But if you have a Net worth of $7m, debt of $14m, earning 5%, with interest costs of 10%. Your equity is the same, your assets are $21m. However instead of earning money, you are losing $350k per year.

    I think it is all about cash flow, not net worth.
     
  16. Waimate01

    Waimate01 Well-Known Member

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    Really good example - I stand corrected that net worth is an in any way useful measure.

    But your excellent illustration does tend to reinforce my previous points that "debt == bad" and "negative gearing == bad". The best way to be rich is to have a lot of assets and not owe much to anyone. You heard it here first ;) Thus the validity of paying down debt.
     
  17. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    ... and a Net worth of $7m, debt of $14m, earning 5%, with interest costs of 10% and growth of 7%. Your equity is the same, your assets are $21m. You have a cashflow drain of $350k per year from holding costs, yet make $1.47m in growth each year, which effectively makes you a profit of $1.12m net per year.

    The whole idea of negative gearing is that there's no point unless you are A) getting enough growth to make a profit overall, and B) can generate enough cashflow (even if from equity) to cover your holding costs.

    Both property and shares show long term average total returns of 12 - 14%, so unless interest rates are above average or you have insufficient buffers in place to deal with the slow periods, then negative gearing can work well.

    To say that negative gearing is always bad is a very short sighted point of view in my opinion.
     
  18. Waimate01

    Waimate01 Well-Known Member

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    It depends on where your comfort levels lie. Mine are that I'm not a believer in magic puddings. But you're very welcome to your own :)
     
  19. Waimate01

    Waimate01 Well-Known Member

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    Interesting to revisit this thread a few months further on.

    The scenario described above now stands a good chance of becoming: "gross worth of $21m sinks to $12.5m, you get a series of margin calls and have to liquidate at the bottom of the market, your expected capital growth doesn't appear and you end up in tatters".

    The Net worth scenario becomes "you shrug, order another latte".

    Net worth has its advantages, particularly when things go to custard. Debt is an amplifier. It amplifies gains and it equally amplifies losses.
     
  20. Nigel Ward

    Nigel Ward Team InvestEd

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    Investment debt is a tool - like a chisel (or perhaps a chainsaw :D). Like such sharp tools it must be used prudently to avoid injury. ;)

    Prudent use of debt would involve, in my view, gearing highly only where you have both*:
    1. a high and dependable free cash flow to service that high debt AND
    2. some cash reserved to reduce the debt down to a more acceptable level if either:
    • you decide to do so because of reduction in, or risk to, your free cash flow; or
    • your financier forces you to do so eg via a margin call and you are unable to address this in another way, such as provided additional security.
    If you lack both of the above then more cautious use of debt, ie a lower LVR is appropriate.

    *[I suppose a third prerequisite would be that you can sleep at night without worrying excessively about your debt level! ] :rolleyes:

    My 2.2c worth.

    Cheers
    N
     
    Last edited: 22nd Oct, 2008