Australian Investor - Mortgage Offset & Margin Loans

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Norton79
Posts: 11
Joined: Tue Apr 26, 2016 8:02 am

Australian Investor - Mortgage Offset & Margin Loans

Post by Norton79 » Thu Oct 03, 2019 10:30 am

Dear all,

Thank you in advance for considering my problem. I am considering to invest using a margin loan instead of money sitting in a mortgage offset account.

I have a mortgage over my principle place of residence in Australia with a mortgage offset account. For those unfamiliar with an offset account, it is essentially a savings account from which the balance is subtracted from the outstanding mortgage debt before interest is calculated. It's kind of like having a redraw facility, without actually contributing additional money directly to the mortgage.

I would like to invest more money in the stock market. The investment would follow my existing investment portfolio of globally diversified index funds. Rather than take money out of the mortgage offset account, I am considering to take out a margin loan, roughly equivalent to half the amount currently sitting in the offset account. The reason for this (using margin loan instead of savings) is that net interest on the margin loan is tax deductible and my marginal tax rate is just shy of 50%. My mortgage interest rate is low 3%s (variable) and the margin loan interest rate would be roughly 5% (variable). If a margin call is made, there would be more than sufficient money available in my mortgage offset account to cover the shortfall.

Do you think this is a reasonable strategy?

Am I completely bonkers trying to gear a portion of my portfolio in the current market? if not, would you consider to try this strategy during a severe market downturn?

Gearing and market timing eek... take it easy on me.

What problems can you foresee?

I am particularly interested in understanding the vulnerabilities, especially as the market and interest rate environment changes.

Thank you
Norton79

andrew99999
Posts: 516
Joined: Fri Jul 13, 2018 8:14 pm

Re: Australian Investor - Mortgage Offset & Margin Loans

Post by andrew99999 » Thu Oct 03, 2019 7:56 pm

Firstly, do NOT use a margin loan because the bank can call that loan in when the market is down. If you go ahead with this, get an equity release as a whole separate loan on your PPOR (tell them you are planning to use it as a deposit for an investment property), and use that instead. This way it is not callable. Do not get a callable loan - if that is your only option I think you should ditch the whole idea - because this is such a serious issue.

On an equity release, along with not being callable, the rate will also be much less than 5%, I'm pretty sure you can get less than 4% now for investment loans. Also do not feel the need to use as much as they give you - that is not how you determine your level of risk.

And yes as you said, this is better than using money in the offset as you get a tax deduction - depending on how much higher . It will also leave you with your offset account as an emergency fund that you have access to.

You will need to speak to an accountant to make sure what you are doing is above board (there are rules you are likely not aware of). A good accountant is not cheap but don't skimp on a good accountant, it is not worth the risk.

As to whether to do it or not, if you
1. have enough spare cash to ride out your house repayments, emergencies, a recession where job losses increase, and still support yourself and any dependants you have
2. don't go nuts and gear to the most that you can borrow just because of how much they gave you
3. have the emotional ability to not freak out and sell low and can sleep at night with the higher risk
4. diversify globally

Then it seems reasonable.

I do like a P&I loan though so that the debt is being reduced over time rather than paying back a lump sum at some later point, this way you don't have to market time and sell any shares to do so, and the debt retires over time.

It's a tough decision, so give yourself plenty of time to look into it and consider all aspects.
PassiveInvestingAustralia.com

Topic Author
Norton79
Posts: 11
Joined: Tue Apr 26, 2016 8:02 am

Re: Australian Investor - Mortgage Offset & Margin Loans

Post by Norton79 » Fri Oct 04, 2019 12:17 am

Thanks Andrew999999, great feedback. I didn't realize a margin loan could be called in completely, not just a margin call. I certainly would not want that during a severe market downturn, even though the money would be sitting in the offset account.

Your idea of an investment loan is an interesting one. I would have thought the bank would hold the mortgage over any investment property, rather than allowing me to access the funds and invest elsewhere. It doesn't sound 100% above board, which again would make me feel uncomfortable. I will look into it though because lower interest and tax deductible are some of my favorite words. If I'm not mistaken, a home equity loan is not tax deductible, which combined with a slightly higher interest rate (than the interest on PPOR) would not be ideal. I'd have to run the numbers, but I expect it's better to use the money from the offset account.

As for risk tolerance. I am well aware that I started investing (properly) during an extremely good period for the share market. The biggest market declines I've experienced so far include a 15% drop 3 months after I started investing and 15-20% late last year. Both times were fine, but hardly a test for the bad times. To that end, any strategy I do employ will be thought through very carefully and not rushed. My initial gearing ratio would be in the order of 10% of total investable assets and less than 50% of available cash (in offset) to allow me to understand how the investment works and my response to market fluctuations. Over the long term, the gearing ratio may increase or may not, but your words of warning are well noted. You may wonder why bother if it's only 10% of AUM, but it's primarily about learning and caution, at least initially. At this stage it's only theoretical, until I become comfortable with the idea. I would like to continue paying down the mortgage (building up the offset) for another 2 - 3 years before considering to take on this approach, but if the market did take a severe downturn and I was comfortable with the decision, I'd consider doing this sooner.

All good points, thank you.
Norton79

Taxable: VAS (30%), VSO (10%), VTS (25%), VEU (25%) and IEM (10%).
Super: Australian Equity (27.5%), International Equity (27.5%), Property (Domestic/International)(30%), Bonds (15%).

andrew99999
Posts: 516
Joined: Fri Jul 13, 2018 8:14 pm

Re: Australian Investor - Mortgage Offset & Margin Loans

Post by andrew99999 » Fri Oct 04, 2019 12:57 am

Norton79 wrote:
Fri Oct 04, 2019 12:17 am
Thanks Andrew999999, great feedback. I didn't realize a margin loan could be called in completely, not just a margin call.
I don't know how much they can call in, but why put yourself in that position at all, especially when there is a better option.

Edit: just noticed you were considering 10%. In this case I think margin is ok, but you can use NAB equity builder which is a loan for shares (P&I) and I *think* it is not callable. I'd still prefer an equity release from PPOR, but NAB equity builder would be my next choice.
Norton79 wrote:
Fri Oct 04, 2019 12:17 am
Your idea of an investment loan is an interesting one. I would have thought the bank would hold the mortgage over any investment property, rather than allowing me to access the funds and invest elsewhere. It doesn't sound 100% above board, which again would make me feel uncomfortable. I will look into it though because lower interest and tax deductible are some of my favorite words. If I'm not mistaken, a home equity loan is not tax deductible, which combined with a slightly higher interest rate (than the interest on PPOR) would not be ideal. I'd have to run the numbers, but I expect it's better to use the money from the offset account.
It is 100% above board.
They lend you money and instead of other shares being collateral (which can drop in value and force a margin call), your existing property is the collateral and its incredibly unlikely for the bank to call in a loan on a property and I've never heard of it happening. As long as they have your property as collateral they're good.

What makes the interest tax deductible is not where the money comes from, but what you invest in. Whether you borrow from your PPOR or on margin doesn't matter. It is based on investing in income producing assets that makes the interest tax deductible.
Norton79 wrote:
Fri Oct 04, 2019 12:17 am
Taxable: VAS (30%), VSO (10%), VTS (25%), VEU (25%) and IEM (10%).
Super: Australian Equity (27.5%), International Equity (27.5%), Property (Domestic/International)(30%), Bonds (15%).
A lot of REITs so I hope you are aware of what happened to REITs in the last crash.
Otherwise Looks quite reasonable, nicely done.
PassiveInvestingAustralia.com

Topic Author
Norton79
Posts: 11
Joined: Tue Apr 26, 2016 8:02 am

Re: Australian Investor - Mortgage Offset & Margin Loans

Post by Norton79 » Fri Oct 04, 2019 2:19 am

Thanks again for the follow up Andrew99999. It looks like there are a couple of good options and I'm glad I reached out. I will investigate both the NAB Equity Builder and the equity release options. REITs are 30% of Super, but only 10% of overall portfolio. I'm overweight REITs and Bonds in super for tax purposes. In a low interest rate environment, there is a lot of downside risk with the REITs, but I've kept that allocation for almost 10 years now and I'm going to stick with the buy & hold strategy. I am underweight Bonds overall, but I struggle with having both a mortgage and bonds. I know the arguments for having bonds regardless. I'd prefer to have a reasonable cash position in the offset to help me sleep at night.

andrew99999
Posts: 516
Joined: Fri Jul 13, 2018 8:14 pm

Re: Australian Investor - Mortgage Offset & Margin Loans

Post by andrew99999 » Fri Oct 04, 2019 4:00 am

Ah ok can't see issues with 10% and yes better in super as you said.
Money in the offset is better than bonds for your bond portion. Looks like you planned well.
PassiveInvestingAustralia.com

Valuethinker
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Re: Australian Investor - Mortgage Offset & Margin Loans

Post by Valuethinker » Fri Oct 04, 2019 4:22 am

andrew99999 wrote:
Fri Oct 04, 2019 12:57 am
Norton79 wrote:
Fri Oct 04, 2019 12:17 am
Thanks Andrew999999, great feedback. I didn't realize a margin loan could be called in completely, not just a margin call.
I don't know how much they can call in, but why put yourself in that position at all, especially when there is a better option.
I believe the North American stockbroker agreements include a provision that they can cancel the margin agreement at any time - in effect call the entire loan. Of course that would be in "extraordinary circumstances". Well let me tell you about Royal Bank of Scotland, something like 5-6th biggest bank in the world, and they were calling personal loans (used for buying cars, etc.). And they were essentially bust without a £28 bn equity injection from the UK government.
Edit: just noticed you were considering 10%. In this case I think margin is ok, but you can use NAB equity builder which is a loan for shares (P&I) and I *think* it is not callable. I'd still prefer an equity release from PPOR, but NAB equity builder would be my next choice.
Norton79 wrote:
Fri Oct 04, 2019 12:17 am
Your idea of an investment loan is an interesting one. I would have thought the bank would hold the mortgage over any investment property, rather than allowing me to access the funds and invest elsewhere. It doesn't sound 100% above board, which again would make me feel uncomfortable. I will look into it though because lower interest and tax deductible are some of my favorite words. If I'm not mistaken, a home equity loan is not tax deductible, which combined with a slightly higher interest rate (than the interest on PPOR) would not be ideal. I'd have to run the numbers, but I expect it's better to use the money from the offset account.
It is 100% above board.
They lend you money and instead of other shares being collateral (which can drop in value and force a margin call), your existing property is the collateral and its incredibly unlikely for the bank to call in a loan on a property and I've never heard of it happening. As long as they have your property as collateral they're good.

What makes the interest tax deductible is not where the money comes from, but what you invest in. Whether you borrow from your PPOR or on margin doesn't matter. It is based on investing in income producing assets that makes the interest tax deductible.
Norton79 wrote:
Fri Oct 04, 2019 12:17 am
Taxable: VAS (30%), VSO (10%), VTS (25%), VEU (25%) and IEM (10%).
Super: Australian Equity (27.5%), International Equity (27.5%), Property (Domestic/International)(30%), Bonds (15%).
A lot of REITs so I hope you are aware of what happened to REITs in the last crash.
Otherwise Looks quite reasonable, nicely done.
[/quote]

A lot of this is Australian specific. I got "NAB" and then stopped ;-).

Re original poster and weightings - I believe the preference for Australian equities is about dividend "franking"? However that only applies in taxable accounts? Is that benefit claimable in pension funds (superannuation) as well?

Canada I suggest investors otherwise stick to 10% in their home market, or less. The sectoral concentrations are similar - 80% of the Canadian index is natural resources (with a heavy oil sands tilt) + financials. Australia I think is very similar.

Topic Author
Norton79
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Joined: Tue Apr 26, 2016 8:02 am

Re: Australian Investor - Mortgage Offset & Margin Loans

Post by Norton79 » Fri Oct 04, 2019 7:31 am

Valuethinker, thanks for providing RBSC as an example. It's a timely reminder that no institution is too big to fail. It's difficult to fathom in Australia because the big four are so dominant, but that doesn't mean it can't happen.

You're right, the overweight Australian Equities is primarily due to franking credits and home currency effects. There is also an element of past performance (make of that what you will) and the psychological benefit of not lagging the local stock market. From what I've read on this forum, most Aus people seem to have about a 1/3 Australian equities. Having said that, VAS performance has fairly well matched VEU (World ex-US) over the past 7 years in AUD terms, so maybe the home bias isn't warranted (at least in the rear view mirror). VTS has shot the lights out though, 20% p.a compounded over that time!

Super funds do receive franking credits which I believe can be used against the total tax owed for the fund/investor. I'm not sure what happens to unused credits, but I have a net tax bill on Super, so unaffected by this. I'm happy to be corrected on these points.

Thanks again
Norton79

Valuethinker
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Joined: Fri May 11, 2007 11:07 am

Re: Australian Investor - Mortgage Offset & Margin Loans

Post by Valuethinker » Sat Oct 05, 2019 8:41 am

Norton79 wrote:
Fri Oct 04, 2019 7:31 am
Valuethinker, thanks for providing RBSC as an example. It's a timely reminder that no institution is too big to fail. It's difficult to fathom in Australia because the big four are so dominant, but that doesn't mean it can't happen.

You're right, the overweight Australian Equities is primarily due to franking credits and home currency effects. There is also an element of past performance (make of that what you will) and the psychological benefit of not lagging the local stock market. From what I've read on this forum, most Aus people seem to have about a 1/3 Australian equities. Having said that, VAS performance has fairly well matched VEU (World ex-US) over the past 7 years in AUD terms, so maybe the home bias isn't warranted (at least in the rear view mirror). VTS has shot the lights out though, 20% p.a compounded over that time!

Super funds do receive franking credits which I believe can be used against the total tax owed for the fund/investor. I'm not sure what happens to unused credits, but I have a net tax bill on Super, so unaffected by this. I'm happy to be corrected on these points.

Thanks again
Norton79
What is VTS?

If I put 100k into UK index I have put something over 10k into Royal Dutch Shell and 4k into HSBC. That's a lot of concentration.

If i put 100k into Canadian index i have put basically 40k into 5 banks.

2 of the world's most over valued housing markets are Toronto and Vancouver. Personal debt to GDP for Canada is higher than USA in 2006. Ontario is in the top5 of indebtedness for s sub national jurisdiction in the world (think NSW).

The other big linkage for Canadian stock market is the oil price where Canada is the worlds most expensive onshore producer, a combination of oil sands heavy oil plus pipeline shortage means a lot if it goes by train tanker.

This is not a comfortable place to be. Far too concentrated on a very few pillars.

And so Australia which I believe has similar exposures in Sydney Melbourne re housing, very high personal debt. The exposure of Australian economy is more to iron prices than oil and gas, and fracking is not destroying your largest customer's demand.

This makes me want to diversify. Yes US tech stocks are probably overvalued. But the Canadian exposure to China's debt situation plus domestic property bubble is far greater.

Then you throw in a trade war and breakdown of NAFTA.

Watch this space.

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whodidntante
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Re: Australian Investor - Mortgage Offset & Margin Loans

Post by whodidntante » Sat Oct 05, 2019 9:24 am

If you have a mortgage and stocks, your portfolio is already leveraged. Buying stocks on margin will increase your leverage. Leverage of any form will increase your exposure to the market beyond the assets you have to invest sans leverage. This increases risk. If the borrowing rate is lower than the expected returns of the asset classes you are investing in, it also increases expected returns in absolute terms.

With a margin loan specifically, you should be concerned with risk of ruin, which would show up as your broker liquidating your assets to bring you back in line with maintenance margin. Or in a terrible case, total liquidation with money still being owed to the broker. A margin loan of 15% of your securities, assuming you invest in broad indexes, is extremely unlikely to ever ruin you. Keeping a mortgage to invest in securities also has a risk of ruin, in that you might lose all your money, not pay the mortgage, and lose your house.

You can also use futures, which don't require nearly as much capital for the exposure obtained and allow borrowing at the risk-free rate. For a given amount of leverage, futures would have a lower risk of ruin. Futures are also taxed differently in the USA. I don't know about Australia.

You should also be aware that a 100% stock portfolio is beyond the risk tolerance for many people, and fewer still can hold 115% stocks. I suggest avoiding extreme forms of leverage, e.g. 100's of %, unless you're certain that's what you want and you can deal with the repercussions.

Topic Author
Norton79
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Re: Australian Investor - Mortgage Offset & Margin Loans

Post by Norton79 » Sat Oct 05, 2019 2:28 pm

You're right about concentration risk Valuethinker, but as you elude to, everything is over priced (compared to historical) and there are clear and present dangers for all markets. I think it's a case of choose your poison, because it's hard to see where you can hide in this environment. You've certainly given me something to think about though and I will ponder my asset allocation for a while longer.

Whodidntante I was waiting for the counter argument and you've made some excellent points. The risks you point out can't be ignored, even if they seem highly unlikely to me. I've got to ask myself what do I expect to achieve by leveraging a small portion of my portfolio, and the answer is probably not a lot. It certainly wouldn't bring my retirement forward by a lot, and so why take the extra risk. And as you say, until I pay off the mortgage I am technically leveraged anyway. To prove the point, I could have liquidated my stocks when I bought the house and owned it outright, but instead chose to take out a mortgage, and in doing so, effectively took out the loan to keep my portfolio. I never really gave it much thought, probably because the loan feels safe as houses (excuse the pun), but in the back of my mind I knew it to be true.

Thank you both for your insights.

Topic Author
Norton79
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Joined: Tue Apr 26, 2016 8:02 am

Re: Australian Investor - Mortgage Offset & Margin Loans

Post by Norton79 » Sat Oct 05, 2019 2:48 pm

Valuethinker wrote:
Sat Oct 05, 2019 8:41 am
Norton79 wrote:
Fri Oct 04, 2019 7:31 am

What is VTS?
VTS - US TSM index on ASX in AUD. Currency effects have helped a lot (AUD almost halved in USD terms over that period), together with the US performing well.

Valuethinker
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Re: Australian Investor - Mortgage Offset & Margin Loans

Post by Valuethinker » Sat Oct 05, 2019 3:41 pm

Norton79 wrote:
Sat Oct 05, 2019 2:48 pm
Valuethinker wrote:
Sat Oct 05, 2019 8:41 am
Norton79 wrote:
Fri Oct 04, 2019 7:31 am

What is VTS?
VTS - US TSM index on ASX in AUD. Currency effects have helped a lot (AUD almost halved in USD terms over that period), together with the US performing well.
The falling AUD is the way the Australian economy preserves its general standard of living when terms of trade (ratio export prices to import prices; in effect how commodity prices are doing in real terms) go against it. Contrast to the 1930s when Australia was about the worst hit country in the British Empire - Gold Standard, no ability to cut prices (in foreign currency terms) as commodity prices plunged. Some of the states (this is vague and from memory) nearly went into bankruptcy.

So the AUD falls, imports get more expensive, foreign travel gets more expensive, but Australian-produced goods and services (food, healthcare) do not, and of course you have a tourism boom. A side effect is that foreign buyers find Australian RE correspondingly more attractive.

But you can't count on that - the past performance due to currency weakness can be reversed.

So that leaves the difference in index performances, exchange rate left constant.

The US, because of 2 main factors, has outperformed every other major index in the world since the financial crisis:

- a group of internet stocks, led by the FAANGs (+ Microsoft) have become the largest listed companies in the world- -except for the 2 Chinese internet giants. Apple had the largest corporate profits ever recorded, and the largest cash pile of any company ever recorded. If you look at say 2000, and the top 10 stocks then, you see basically only Exxon, now? Farewell, GE

- the US economy has recovered faster and stronger than any other major economy in the world, and in particular the US banking stocks have far outperformed their European counterparts, post crash

Will these factors continue?

Who really knows?

Betting on the US market in Australian dollars because of 2 factors that might or might not repeat themselves is not a good investment strategy. Efficient markets theory teaches maximum diversification, not chasing performance.

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