Simple way to use debt to make an extra $23,700 per year

A financial adviser has revealed that debt can be very lucrative when used right – and the average Aussie could be making an extra $27,000 a year.

Borrowing to invest allows you to use the bank’s money to get ahead, which can fast track your investing. You can get ahead without borrowing, but your progress will always be slower going and harder fought.

There are two big reasons why using smart debt as part of your investment strategy should be on your radar.

Accelerate your wealth building

When you borrow money to invest, you end up with more investments than you could buy with just your savings alone. This means more investments growing for you, and therefore more investment profits.

Say for example you have $100,000 saved and you’re considering whether to invest into shares or property. If you were to invest the money into shares, based on the long term sharemarket return of 9.8 per cent, your expected return would be $9,800 over the next 12 months.

If instead you were to use the $100,000 as a deposit and borrow funds to buy a $500,000 property, your expected return based on the long term property growth rate of 6.3 per cent would be $31,500 ($500k x 6.3 per cent).

That’s a $21,700 higher investment return from the same money. Further, it shows that even though the long term return on property is slightly lower, your absolute return would be higher because your investment is five times as large ($500k vs. $100k).

Top down drone view of a small neighbourhood of mid-century Australian homes and yards on a quiet street in the outer suburbs of Melbourne

Tax breaks

On top of the benefit of debt mentioned above, under the tax rules in Australia there’s another serious upside of using debt to invest. Any time you use borrowed money to invest, all your borrowing costs are tax deductible – meaning you get to invest more and cut your tax bill at the same time.

When your interest costs are tax deductible, this effectively reduces the ‘after tax’ cost of your borrowing. You can calculate your after tax interest rate using the formula below:

After tax interest rate = before tax interest rate x (1 – marginal tax rate)

Using some real numbers, if you take out a mortgage from the bank with a headline interest rate of 6 per cent, and your marginal tax rate is 34.5 per cent (based on an income above $45k p.a.), your after tax interest rate would be:

After tax interest rate = 6 per cent x (1 – 0.345)

After tax interest rate = 3.93 per cent

And if your marginal tax rate is higher, it gets even better. If you’re on the top marginal tax rate of 47 per cent, we can calculate as follows:

After tax interest rate = 6 per cent x (1 – 0.47)

After tax interest rate = 3.18 per cent

You can see from these figures that your after tax borrowing costs are between 2-3 per cent lower than the headline interest rate.

When your borrowing costs are lower, it means your investment will make you more money after costs and tax, which is really the only return that really matters when planning your wealth building strategy.

Under the tax rules in Australia there’s another serious upside of using debt to invest.

If you consider a property investment, based on the long term return on the property market of 6.3 per cent you can see the upside of borrowing to invest into property in the example below.

If you were to buy a $1 million property, the expected growth based on the long term return of 6.3 per cent would average out to $63,000 annually. If you were to borrow to purchase this property based on the after tax interest rate above (3.93 per cent), your annual borrowing costs would be $39,300.

This means your total return after borrowing would be $63,000 – $39,300, or $23,700 annually. Worth noting that this is only based on the property growth and interest costs and is before you receive a single dollar in rental income on your investment property.

The numbers are compelling.

You have to manage your risk

Every investment strategy comes with risk, and it’s important this risk is considered and managed well. If you’re borrowing to invest, you need to consider your risk management even more carefully.

It’s obvious but worth noting that if you don’t choose a good investment that will grow, you won’t make money. When you’re selecting your investment, take the time to choose a quality investment that will deliver you solid long term returns.

If you’re borrowing to invest, you need to consider your risk management even more carefully.

The other big risk to manage is your ‘cashflow’, which is something particularly important today in a cost of living and inflation crisis where every dollar counts. If you can’t afford to fund your investment and cover the spending you want or need to do, you’ll end up under pressure. Take the time to understand and plan around your cashflow to make sure your investment will actually work for you.

The wrap

Debt can be scary, and it’s natural to be concerned about facing excessive risk that can cause you trouble. But ultimately, much of the risk that comes from borrowing to invest can be well managed if you’re smart with your planning.

The benefits of using debt to invest are compelling, more investment returns faster, and then you’ve got the tax breaks on top. Debt isn’t for everyone, but for most people, when used well it’s one of the most effective ways to accelerate your progress.

Ben Nash is a financial adviser and founder of Pivot Wealth, a money management company that helps people invest smarter. Follow Ben’s content here: Podcast | Free events | Books | Instagram | TikTok | Facebook

Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.