long term shares investing - using margin loans or offset account

[ottg]

Just to clarify this - this thread is not about how to select shares for LT investments but rather about a mechanism to increase your market exposure; thus your capital growth potential. This is similar to leveraging in an investment property using other people's money (mortgage loans). Market exposure is always a two edge sword meaning that exposure also means larger exposure to losses. For the latter you can limit your downside but using stop losses. While you don't have control over the markets there are only two things you can control; that is the size of your investment when taking position AND the amount that you allow yourself to loose when you exit the position. While this sounds like trading it is just good money management tips obtained from that and applied with long term share investments. How much of that control can you exercise in your own Super when managed by someone else (just a thought)?

Background: You can buy $1000 of shares and own them outright using all your own capital ($1000) or you can borrow say 50% (the LVR allowed) using $500 of own money and $500 borrowed money. Put differently if you had $1000 you can now borrow and purchase $1500 worth of shares and have larger market exposure. You can borrow through your home loan offset account or through a margin loan. The offset account usually attracts lower interest fees than a margin loan. A margin loan can be recalled at anytime by the bank when the value of the shares depreciate to a value where the LVR rate now exceeds say 50%. Thus its less stressful if you work through an offset account because this rule doesn't apply providing you have equity in a property.

Shares provide capital growth and dividend income. You pay taxes on capital gains, dividend income (depending if franked or unfranked), and you pay interest on margin loans. You also have other expenses like account fees, service provider, stock brokerage fees and lots of other smaller fees. You cannot roll over losses from one financial year to the next. But I think you can write losses off against you person income tax similar to investment property (will still check this with my accountant)

Quite a mouth full AND a financial planner CANNOT help you here!!! End!! You need a savvy accountant that is also in investor - they know! With all these expenses you need to run a 'what if' analysis to see what is the best options available taking into account what is your real risk and what if the market goes peer shape meaning if you hit your stop loss say at -15%. Once you have a thorough understand and feeling of the numbers your fear is less.

My next post will be about some of the number crushing. BUT can you see the similarities with investment properties it's just another investment vehicle, market and the rules are different.

[ottg]

I have either copied or borrowed some of these figure from other postings elsewhere but found it useful enough to share.

Lets assume you have a Line of Credit (LoC) on your house's equity (offset account), which cost you say around 4.5%.

Thus interest rate is 4.45%

If tax rate is 39% (including medicare)
Therefore I receives 61 cents for every dollar I earns $1-$0.39=$0.61 cents in hand.
So to convert the 4.45 to before tax the formula is:
4.45 / 0.61 = ~7.3%
If you are on the lower tax rate of 34.5% (including medicare)
4.45 / .665 = ~6.8%

a.) Interest is tax deductible, better than paying 4.45% non-deductible.

b )Better than margin loan at 6.4% and the risk of a forced sell due to recall by the bank

With LoC, if share investment (including franking) returns >5% you win.
If you're on 34% tax bracket, using your offset money requires 6.8% return to break even.

Say you take 100K out of offset account, thereby incur $4450 more on mortgage interest.
If this 100K's worth of shares pay $4760 dividend + $2040 franking credit = total $6800 (i.e. 6.8%) taxable income.
Lets assumed you're on 32.5% tax rate + 2% medicare, taking $2350 tax from $6800 leaves you $4450 net.
You breaking even.
BUT if you get a 5% LoC, $6800 income minus $5000 deductible interest = $1800 taxable income.
Less 34.5% tax leaves you with $1180 net profit while you still enjoy the $4450 offset

You need to earn the equivalent of 7.3% pre-tax to get the same benefit as the 4.45% offset.
So the real question is how taking on more debt is better?

The capital growth has not been taken into account above. Picking and selecting the correct long term shares. (More above this later as my preliminary investigation shows that +20% is possible with no trading)

The same way you pick and select the best area to buy investment property.

And if a property cost say $300,000 then the above numbers need to be multiplied by 3 etc.

Edited June 18, 2015 by ottg

[ottg]

While I'm doing this for myself I hope it may help someone else - thus a few notes.

All we did in the previous post is to say ok my dividends will be able to cover the borrowing cost of my margin loan.
We need to calculate LVR on margin loans as they are slightly different. (attached doc shows how)

1. We need to know the optimum required share growth with each loan type:
a. the lowest growth I need on my shares for the safest LVR for the margin loan
b. the most likely growth I need on my shares for the safest LVR for the margin loan
c. the lowest growth I need on my shares using and offset account loan
d. the most likely growth I need on my shares using an offset account loan
2. The most likely growth without a loan.

Then do a 'what if'analysis to get a thorough understand and feeling for the “what if” numbers for different scenarios

This document give the results:

The optimum results:
a. for 8% growth the LVR need to be 25% (loan $100k) so that row 14 never exceeds 70%

Thus net after 11years ~$580k. Compounded growth is 17% due to leverage.
b. for 20% growth the LVR need to be 55% (loan $180k) so that row 14 never exceeds 70%.

Thus net after 11 years ~$1.4m. Compounded growth is 27% due to leverage.

-The risk in both cases were exactly the same – which one will you prefer??

-Not taken into account is that as your equity growths you can increase your margin loan accordingly which will then result in further exponential growth.
-- If you do this and you monitor your LVR then your risk still stays exactly the same

Edited June 20, 2015 by ottg

[Gerhardk]

Nice posts.

It is great while the shares increase in value and / or pay dividends but I am an accountant and I have seen people lose money on this since they did not have a proper strategy and / or not willing to use stop losses and hope it will get better but then exit at the bottom.

Unless I misunderstood your post, to add to your post, the interest should be deductible on your offset account also and you get franking credits (if franked) as a credit. So using your example yesterday of taking money from offset, I think your income will be $6800 dividend and franking credit - $4450 interest so taxable income = $2350 and taxed at 34.5% = $810 tax, you then have $2040 from your franking credit so you should get refund of $1230 from ATO. Cashflow it cost -$4450 interest + $4760 dividend (franking is credit not cash) + $1230 from ATO = $1,530 positive. Ignoring other costs mentioned such as accountant / broker etc.

Holding shares longer than 12 months should give you a 50% discount on capital gains if you sell and any losses from the sale will be capital loss that can be used against future capital gains. Assuming you are not trading in shares.

[ottg]

Thanks @GerhardK - any losses from the sale will be capital loss that can be used against future capital gains.

That was exact the part I wasn't sure about as I mentioned somewhere you cannot rollover losses (which you can :-) It just gets better!!

How does the ATO classify a trader?

[Gerhardk]

See the link below.

https://www.ato.gov.au/General/Capital-gains-tax/In-detail/Shares,-units-and-similar-investments/Claiming-losses-from-the-disposal-of-investments/?page=4

[Shampoo]

This is not for novices as one would have to do some years of studying stocks, markets, charting, indexing etc. I did this on the ZA markets for years and found the tax far too high. In SA one would have to hold the stocks for a minimum period of 3 years to be considered capital in nature and this makes it impossible to benefit from the lower capital Gains Tax.

Chances are near zero that one would hold a stock for the minimum period of 1 year as required by the ATO. Costs are also higher for holding for long periods due to time erosion.

Not sure if Australia has a trading forum such as sharechat.co.za where one could get good advice and tips.

[Donovan83]

I think that as a person with a life and a non-stockbroking job, it' makes more sense to invest in a fund like Vanguard or something. They do this for a living, may as well let them do it. Low cost, good diversified returns. Safe.

I wouldn't dream of borrowing money to speculate on the stock market for the same reasons I wouldn't stick with a mortgage to buy into the property ponzi scheme right now.

[monsta]

Hey,

Has anyone invested in one if the high return managed funds like Colonial First state or Perpetual?

Would anyone recommend it over a nice fully franked share like commbank? Or even an indexed fund from vanguard?

Oh and @Donnovan83 I will sell you my house, its a fantastic investment! just ask my real estate agent or ask your bank when you apply for a loan!

Edited June 28, 2015 by monsta

[ottg]

@Shampoo - you can try http://www.aussiestockforums.com/forums/ Approx 60,000 members

Majority is about trading while the participation by members in long term investments are limited. However pretty good for technical questions.

Then you can try http://forums.whirlpool.net.au/forum/150?g=387 I found them more responsive for general questions.

As always commonsense prevail!!

[ottg]

speculate on the stock market

The moment you invest in a share and you cannot clearly substantiate why you did it, then you speculate. If the answer includes: "I'm hoping, not sure or may be" then shares investment may not be for you!

A process like this is not speculative:

http://www.saaustralia.org/index.php/topic/45032-long-term-share-market-investments-via-superfund-help-me/?p=410390

But such a process do need more work, must be back tested, compared against others (eg barefoot investor, Motley's fool) and then proven over time. Once proven you keep it tightly to your chest!