Unprecedented times. Unusual times. Uncertain times.
This is first and foremost a health crisis, with an extraordinary economic impact. I by no means intend to detract from those who have been affected directly by the virus, whether personally or family or friends. That said, this is a financial blog and hence my focus.
The world has changed in such a short period, from so many perspectives. And life after Covid-19, will surely be very different.
How will the government prepare for the potential of future pandemics? Will the government support local manufacturing of ‘critical’ products through grants, subsidies, tariffs etc? Will the government continue to provide financial support to job seekers, job keepers and small and medium businesses, if lockdowns are extended?
What industries will survive? And which will fail? How have businesses protected themselves? Which businesses successfully pivoted their strategy?
What new technology will be born?
How will individuals better prepare themselves? Will there be a reset from consumerism to minimalism and self-sufficiency?
Will the Australian property bubble burst? What will be the extent of rental and mortgage defaults, post government stimulus and repayment holidays?
So many questions, only time will tell.
For me, it’s a time to be prepared, remain resilient and be opportunistic.
I’m in a fortunate position to have a strong financial foundation, disciplined investing strategy and ready to take advantage of opportunities.
Let’s take a look…
In such uncertain times, cash is king.
Preserving cash is paramount to cover your essential expenses such as a roof over your head, food on the table and keeping the lights on. That said, anxiety is elevated as we don’t know when life will return to the ‘new’ normal, businesses reopen, jobs return and the economy kickstarts again.
So, first and foremost a strong cash buffer, commonly referred to as an emergency fund, is a pillar of personal financial security and resilience. Rule of thumb (excluding retirees) is 3-6 months worth of living expenses, however with the uncertainty of how long the government lockdown will actually last, the more the better. Secondly, consistent and secure income will keep you comfortably on your feet and settle the nerves, but this will be easier said than done for a lot of people.
Now, what becomes significantly important is – cashflow.
Maintaining income and reducing expenses. A silver lining here is that a lockdown means discretionary spending should be significantly reduced – think shopping, dining out, entertainment, social events etc. With more time on our hands, there are no excuses to avoid working on our finances, specifically improving cashflow, for example:
- Review your expenses with respect to the current situation
- Switch lenders for a better mortgage rate and/or cashback
- Reduce bad debt with additional payments or maximise your mortgage offset, if possible
- Review and compare insurance policies e.g. health, car, house and contents
- Review and compare utility bills e.g. electricity, gas, internet, phone
- Suspend/cancel unused subscriptions e.g. gym, pool, yoga
- DIY / insource rather than outsource e.g. gardening, handyman repairs
Personally, I have been building a strong cash buffer in my offset account. Such readily available liquidity serves three purposes:
- Emergency fund
- Reduces non-deductible interest on my mortgage
- Investment opportunities
Since I have put my existing investments, discussed below, into autopilot it’s number three that excites me during such uncertain times. As Warren Buffett is so often quoted:
Be fearful when others are greedy, and be greedy only when others are fearful.
Investment Property (IP):
No change to my strategy here – IP mortgage repayments are set to minimum. Since the associated interest is tax-deductible, it is more optimal to redirect excess cashflow to non-deductible debt i.e. PPR mortgage. Note that the interest rates on both of my mortgages are the same.
I should make the point that this mortgage is principal and interest (P&I), not interest only (IO). Meaning there is potential for further tax benefits. However, the backstory here is that I paid off over two-thirds of this mortgage prematurely when I was living there, where in hindsight, I should’ve kept excess cash in my offset to redeploy more effectively later. A point worth mentioning is that the tax man doesn’t let you redraw on a PPR mortgage when converting to an IP mortgage.
Given the repayments on the IP mortgage balance are quite manageable and the delta between P&I and IO rates is considerable, 1.5% in fact, it was less of headache to leave the loan structure unchanged.
But…I prefer to validate my thinking with some logic, rather than just emotion. Remember at tax time, I wouldn’t be refunded the full difference between the two rates, the additional 1.5% interest expense from the IO mortgage would just reduce my taxable income. Let’s run some ‘round’ numbers, all else being equal:
|P&I Mortgage||IO Mortgage|
|IP mortgage amount||$100k||$100k|
|Additional interest expense||–||$1.5k|
Now, remember that with the IO mortgage I would’ve been out of pocket an extra $1.5k, so my take home pay would actually be $75,503 and $74,558 ($76,068-$1,500) for the P&I and IO mortgages respectively. Evidently almost a grand is saved in this example with a P&I approach provided you have the cashflow for the repayments. Mathematically, when claiming tax deductions, for such expenses, you are only refunded your marginal tax rate i.e. 37% in the above example.
Worth noting, the above simplified example did not account for the fact that P&I repayments continually reduce the interest, due to principal down payments. Reduced interest means less tax-deductions. I’m conscious of this however remained discouraged given the remaining balance and the pain of refinancing an IO mortgage every 5 years before it converts to P&I.
Bit of a tangent there, long story short, the maths checks out and it is in my financial interest to keep the IP mortgage as P&I given I can afford the repayments.
Primary Place of Residence (PPR):
Nothing special here, just good old fashioned disciplined saving.
Minimum repayments but maximise cash in my offset, to reduce non-deductible interest.
I learnt my lesson with my IP above paying off the mortgage principal in advance. Therefore, I shovel everything into my PPR mortgage offset, for liquidity reasons previously mentioned.
Remember, cash in your offset is a guaranteed tax-free return. Yes, interest rates are at record lows, but your mortgage rate will always be higher than any ‘high’ interest savings, term deposit or fixed interest account. Grossing that rate up to a pre-tax figure is actually quite pleasing. For example, my current mortgage rate is net 2.84% or gross 4.5% (= 2.84% / (100 – 37%)) at a 37% marginal tax rate. Even more at the highest tax rate!
No change to my strategy – salary sacrifice each month to maximise up to the government’s $25k p.a. concessional contribution limit.
Not only is this a dollar-cost-averaging strategy in itself, there is a considerable tax arbitrage i.e. 15% compared to your marginal tax rate.
Well, this is sounding like a broken record – no change.
I guess that’s reassuring though. I’m staying true to my overall strategy. Consistently investing through the full market cycle of peaks and troughs.
The structure of investment bonds allows you to increase your yearly contribution by 125%, based on the previous year. The table below shows the step change over the years. I kickstarted my bond with $30k and am on track to achieve the $37.5k this year. That said, the 125% rule compounds exponentially, so I won’t be able to continue with equivalent contributions in the following years.
|Investment Bond Year||Financial Year||Max. Annual Contribution*||Max. Monthly Contribution*||Actual Contribution|
*Based on initial contribution in Investment Year 1.
What I did learn after my first year, was to set my contributions to autopilot with monthly direct debits. During the first year I set a very low monthly contribution ($200) and withheld cash until the very end as I felt there was a market correction due. Ultimately, I was trying to ‘time the market’. Being honest with myself, I’m not that smart, so I shouldn’t try to be. Just set dollar-cost-averaging to autopilot and move out of its way!
Actually, I must correct myself, I have made a slight change – to index allocations. All future contributions have a 50/50 allocation of VAS/VGS, from 40/60. My reasoning here is VAS is currently trading at a better discount to its February peak, compared to VGS. That said my long-term allocation for VAS/VGS is somewhere between 50/50 and 40/60.
Yep, no change here – it’s a ‘hold’ from me. I don’t have the appetite to spend copious amounts of time (or have the intellect for that matter) studying individual companies. Not to mention, in a period of widespread uncertainty and business disruptions it would be impossible for me (and most others, I expect) to be able to quantify future cashflows in order to value companies with confidence.
Also, I don’t intend on blindly punting.
Echoing my previous comment – I have to maintain my convictions and follow my indexing strategy.
I’m the type of person that is continuously looking for areas to improve and optimise. I honestly can’t help myself. I also acknowledge it could be detrimental to my overall strategy. That said, I’m not spontaneous enough to dive in feet first to anything without reasonable consideration and calculation. Bottom line – the numbers have to support my ‘gut’ feel. Then, I must appropriately consider if the outcome is only a marginal gain – is it worth the time to implement and any perceived risk?
Enter debt recycling. In short, debt recycling turns non-deductible interest into deductible interest i.e. a pure tax play. In my proposed scenario it would mean paying down a portion of my PPR mortgage in advance, meanwhile opening a new loan facility of equivalent valve for investment purposes. The total amount of debt remains unchanged, however there are tax benefits with this strategy.
Now, there are many ways to skin the cat with respect to investment loan products e.g. mortgage, line of credit, margin call. Each with their own pros and cons. But before I even enter that discussion, I need to analyse the effect of the investment loan interest rate in the debt recycle equation to determine if it is actually worth pursuing.
This analysis does deserve its own post though, coming soon. Assuming I have an excess $100k to invest, I plan to compare the following:
- Reduce mortgage interest – leave cash in offset
- Redeploy offset cash – invest in indexes
- Debt recycle – pay down PPR mortgage, open IP loan facility, invest in indexes
Detailing my strategy above validates that I’ve maintained consistency and reassures me that I remain on track. The key through all of this uncertainty and mixed emotions is blocking the inclination to deviate from my strategy. To summarise:
- Cash – maintain emergency fund
- Cashflow – maximise by maintaining income and reducing expenses
- Investment property – minimum repayments to maximise cashflow and deductible interest
- Primary place of residence – minimum repayments with excess cash in offset to maximise cashflow and minimise non-deductible interest
- Superannuation – maximise monthly contributions to dollar-cost-average during a discounted share market, plus the tax break benefit
- Investment bond – maximise monthly contributions to dollar-cost-average during a discounted share market, plus the tax break benefit
- Individual shares – no change, focus on indexes
- Debt recycle – research and analysis feasibility of converting non-deductible debt into deductible debt