Thoughts on paying down loans

I agree with Sim. For me personally net worth is meaningless. It doesn't buy me the freedom I desire. It's all very nice to go around thinking 'I'm worth $X' but for me, freedom is priceless and that's what I aim for. It's pointless being able to say you've got a whole bunch of assets if you have to work a crap job you hate to finance them. Cashflow buys me that freedom, so that's my focus.

Mark

But chaps, if it's *Net* worth, you don't have to work like crap to finance them - they're paid for. That's the difference between gross worth and net worth. Gross, you may have to work like crap. Net, and they're all paid for, you're down the beach, and they're producing positive yield for you.

Net worth of (say) $7m, no debt, earning (say) 5% fully franked means an effortless income of $350k per year with a bunch of the tax already paid.

Gross worth of $7m but with net worth of only a cuppla hundred grand means you'd better keep your day job !

You're right. I'm in that situation at the moment, paying down debt. But instead of focusing on net worth (as in 'If I have $X net worth I can achieve an income of $Y at Z%) I look at it as 'the more debt I pay down, the higher my passive income'. It's the same thought process, just different ways of thinking about it.

Mark

if I have additional funds the way I managed my debt on my managed funds and Shares is as follows:

I will pay down my debt when I believe the market is at a high.....

and I will increase my capitial base/fund additional borrowings when the market(or underlying investment) is low.

its a conservative strategy but will help you avoid margin calls and become positively geared sooner rather than later. It follows the buffett aproach of being fearful when others are greedy and being greedy when others are fearful.

it stopped me having a margin call over the last 12 months, but it didn't stop me making a paper loss !

But if you have a Net worth of $7m, debt of $14m, earning 5%, with interest costs of 10%. Your equity is the same, your assets are $21m. However instead of earning money, you are losing $350k per year.

I think it is all about cash flow, not net worth.

Really good example - I stand corrected that net worth is an in any way useful measure.

But your excellent illustration does tend to reinforce my previous points that "debt == bad" and "negative gearing == bad". The best way to be rich is to have a lot of assets and not owe much to anyone. You heard it here first Thus the validity of paying down debt.

... and a Net worth of $7m, debt of $14m, earning 5%, with interest costs of 10% and growth of 7%. Your equity is the same, your assets are $21m. You have a cashflow drain of $350k per year from holding costs, yet make $1.47m in growth each year, which effectively makes you a profit of $1.12m net per year.

The whole idea of negative gearing is that there's no point unless you are A) getting enough growth to make a profit overall, and B) can generate enough cashflow (even if from equity) to cover your holding costs.

Both property and shares show long term average total returns of 12 - 14%, so unless interest rates are above average or you have insufficient buffers in place to deal with the slow periods, then negative gearing can work well.

To say that negative gearing is always bad is a very short sighted point of view in my opinion.

It depends on where your comfort levels lie. Mine are that I'm not a believer in magic puddings. But you're very welcome to your own

Interesting to revisit this thread a few months further on.

The scenario described above now stands a good chance of becoming: "gross worth of $21m sinks to $12.5m, you get a series of margin calls and have to liquidate at the bottom of the market, your expected capital growth doesn't appear and you end up in tatters".

The Net worth scenario becomes "you shrug, order another latte".

Net worth has its advantages, particularly when things go to custard. Debt is an amplifier. It amplifies gains and it equally amplifies losses.

Investment debt is a tool - like a chisel (or perhaps a chainsaw ). Like such sharp tools it must be used prudently to avoid injury.

Prudent use of debt would involve, in my view, gearing highly only where you have both*:

1. a high and dependable free cash flow to service that high debt AND
2. some cash reserved to reduce the debt down to a more acceptable level if either:

• you decide to do so because of reduction in, or risk to, your free cash flow; or
• your financier forces you to do so eg via a margin call and you are unable to address this in another way, such as provided additional security.

If you lack both of the above then more cautious use of debt, ie a lower LVR is appropriate.

*[I suppose a third prerequisite would be that you can sleep at night without worrying excessively about your debt level! ]

My 2.2c worth.

Cheers
N