Everyone would like a high income. Why? So they can enjoy spending it. A good income is extremely valuable, but not so much for spending, as for the other opportunities it opens up.
Income gives access to basic needs of food, clothing and shelter. Once they are met it can provide comforts, perhaps even luxuries.
Beyond that a reliable income can service a debt, enabling us to borrow. That is when the real value of a good income is evident. What will we borrow to buy?
We all need wheels. If we dont have the cash to pay cash we must borrow for a car. How much car? We could use our high income to borrow for a hot, new sports car, a fancy four wheel drive or an impressive modern ute.
We can pay it off over several years. Then we will own something. Great. What will it be worth? Usually far less than when we bought it. The interest rate is often high and there are usually no tax deductions for the interest paid.
So borrowing to buy expensive, depreciating assets with high interest, non-deductible loans isnt smart. What about buying a home? We all need a roof over our heads. Still, we could secure a roof by paying rent.
If we buy a home and live in it we miss out on the rent we would have received had we not lived in it. So everyone pays the rent, whether home owner or tenant. Yet borrowing for a home is better than for the hot, new car.
Property usually increases in value over time. Also home loans are usually much cheaper than car loans. So by buying our home and servicing the debt we can grow our equity.
Buy a house for $200,000 with a $180,000 loan. Five years later it could be worth $250,000 and our debt will be $165,000. We may struggle to meet the payments but suddenly our equity is $85,000, a big jump from our initial $20,000.
What if we borrow for an investment property? Thats smart. We are borrowing to buy an appreciating asset. The loan interest is lower. Not only that but, unlike our home, we can claim a tax deduction for the loan interest.
Also the rental income will help us meet the payments. This introduces a new principle. We have bought an income stream. We have increased our income without working. We can service more debt.
We do have to make the payments. This means we must carefully compare the rental income after property costs with the loan payments. How big is the gap? How much will we need to put in? Less is best.
We can also borrow to buy shares and managed funds. The same principles apply as with investment property - capital appreciation, lower interest, tax deductions, buying an income stream. In addition some of the income usually carries tax credits.
Borrowing to buy a business can add a further dimension to the picture. With the investment property the rental income after property expenses may be around 3 per cent per annum. With the shares and funds it may be 4 or 5 per cent.
However with some businesses it can be 10, 12 or 15 per cent, even after paying ourselves a basic wage. The income stream we buy can help pay off the business quickly.
Suppose we buy a $150,000 business with a $100,000 loan. If the business net income is 12.5 per cent of its value the cashflow will pay it off in seven years.
A $750,000 business bought with a $500,000 loan will also pay itself off in seven years. It should then be worth over $1 million which we would own debt free. If we can build the business up it may be worth more.
Not all businesses have high incomes. Farms usually have low incomes and can only service a small debt. Cashflows must be carefully analysed before taking out the big loan. Remember also that businesses involve high risks.
It certainly pays to build up our personal income, and to borrow to buy assets with a healthy income stream attached.
Written By Russell Tym, Authorised Representative of MoneyLink Financial Planning, AFSL No 247360
This article is bought to you by Imperator Financial
and Money Link Financial Planning
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