Invest for the future

Greg, 45, and Jackie, 44, had always planned to pay off their home loan by the time Jackie turned 50. Their house is worth $620,000 and, with only $200,000 to pay off the loan, they're currently on track to achieve this goal.

They want to maintain their current living standard when they stop working and know they'll need to make the most of their income during the next 20 years.

As they've got their home loan under control, they can now turn their focus to building their long-term wealth so they have an income down the track.

To help them do this, they consult with an adviser who identifies smart ways they can invest successfully to achieve their personal goals.

Inefficient debt is used to buy goods, services and assets that don't generate an income. These tend to depreciate in value or have no value once they're used. For example, paying living expenses with a credit card (and not making repayments within the interest-free period), taking out a car loan, and even having a mortgage are classified as inefficient debt.

Efficient debt, on the other hand, is used to acquire assets that have the potential to grow in value and generate income. With this debt, you can claim a tax deduction on the interest and use any income generated to help repay the loan.

Greg and Jackie saw paying off their home loan and investing for the future as two separate strategies.

This is not unusual, as many people wait until their home loan is paid off before they even think about investing. Unfortunately, this means you invest much later in life and don't give your investments time to grow.

Greg and Jackie's adviser takes a different approach. He shows them how they can build wealth by converting their inefficient debt into efficient debt (a process known as debt recycling). While this means it takes slightly more time to pay off their home loan, in the long term this approach has the potential to achieve better returns.

With debt recycling, Greg and Jackie will:

1. use the equity in their home to establish an investment loan (such as a line of credit),
2. invest the borrowed money in assets such as shares; either directly or via a managed investment such as a unit trust, and
3. use the investment income and tax benefits from the geared investment, as well as any surplus cashflow, to reduce their outstanding home loan (currently $200,000).

At the end of each year, Greg and Jackie will borrow an equivalent amount to what they've paid off their home loan and use this to purchase additional investments.

By using this strategy, Greg and Jackie can:

• convert their inefficient debt to efficient debt
• use the income and tax advantages from gearing to further reduce their inefficient debt, and
• grow their long-term wealth faster.

While you may not be comfortable with a debt level of 67%, an adviser can help determine your risk profile.

They'll help you find a level of debt you're comfortable with that also suits your personal circumstances.

Greg and Jackie use the existing equity in their home to borrow for investment purposes. Working with their adviser, they review their goals and decide they're comfortable with a total debt level that's equivalent to 67% of the current value of their home (ie $415,400). Given their outstanding home loan is $200,000, they initially borrow $215,400 via an interest-only investment loan in Jackie's name, which they invest in an Australian share fund via a unit trust.

Throughout the first year, they use all their surplus cashflow, investment income and tax benefits to pay $54,097 off their home loan.

Once they pay this off their home loan, they take out an investment loan of the same amount to purchase additional units in their share fund.

They continue this process until their home loan is paid off. The table below shows the benefits of the strategy over 20 years, compared to paying off their home loan as quickly as possible and directing surplus cashflow into a share fund once the home loan is paid off.

Assumptions: Jackie earns $110,000 and Greg earns $50,000. They have monthly expenses of $4,800 (excluding the home loan). The return on the Australian share fund is 8.5% pa (split 4% income and 4.5% growth). The franking level on income is 75%. The interest rate applying to the home loan and investment loan is 7% pa. These rates are assumed to remain constant over the investment period. The investments and loans are in Jackie's name. At the end of 20 years, all investments are sold, Capital Gains Tax paid and loans repaid.

Value added by strategy over 20 years = $429,415