Appearances can be deceptive, especially when it comes to wealth. Are the couple who have a flashy car, beautifully renovated home and kids at private school and enjoy overseas holidays as prosperous as they look? Or are those trappings of fabulous wealth a debt-infused mirage?
Michael Hutton, head of wealth management at HLB Mann Judd, Sydney, says that while many people may appear to be wealthy, in reality their financial situation can be quite tenuous.
“If people are too dependent on the fortunes of a single asset, or their lifestyle is propped up by borrowings, the appearance of wealth can be quickly shattered,” he says.
“Many home owners think they are wealthy but they are possibly asset rich and cash poor and in some cases struggling to meet their recurring expenses. They are also vulnerable to falling property prices in the short term and rising interest rates in the medium and longer future.”
Keeping up appearances has never been easier, says Adrian Raftery, course director of financial planning at Deakin University.
“Credit card debt has gone through the roof over the last few decades and continues to rise. People have mortgage repayments, credit card repayments and HECS debt as well. They pay those on a month-to-month basis to fund their lifestyle and continually borrow.”
Negative gearing is practically a buzzword now, he says. “Why would you borrow $1.2 million for an investment property and have to repay $50,000 in interest and only get $25,000 in rent?
You’ve got council rates and water rates and repairs and maintenance. Why would you go ahead doing it in the hope of some capital growth? It’s for the perception you are doing a lot better than you are. We say don’t try to keep up with Joneses but it’s amazing how many people do.”
According to AMP.NATSEM’s report Buy Now, Pay Later, the ratio of household debt to disposable income has almost tripled in the past two decades from 64% to 185%. It says rising house prices supported by low interest rates have fuelled “our burgeoning appetite and tolerance for debt”.
Economic growth, low unemployment and resilience through the GFC has led us to rationalise that we’ll be OK.
“My property is now worth this much. Interest rates are low. My job is safe. My salary will progressively increase and relieve the burden. Our monthly cash flow balance is above water. I’ll deal with that large sum later.”
Debt is a powerful way to build wealth but only if managed well, says the report.
“Good debt builds wealth, bad debt diminishes it. Falling on the wrong side of this ledger comes down to how we manage our finances. It’s imperative to factor in the impact if interest rates start creeping back up from their current historic lows and contingency-plan in the event we lose our job or if an unforeseen health event prevents us from working.
“The question is, are we doing enough now to manage our debt in a way that will allow for a prosperous future?”
Financial advisers will tell you the only way to know whether you are doing enough to ensure genuine prosperity is to do a wealth reality check.
That means working out your net position after all your debts and liabilities have been taken into account. It can be a sobering exercise that dispels any delusional, over-optimistic notions of how well positioned you are.
It’s usually one of the first things a good financial planner will do with you, says Colin Lewis, head of strategic advice at Perpetual Private.
“From time to time you need to do a snapshot of your wealth. It is a matter of taking into account what your total assets are and what your total liabilities and commitments are, and that gives you your financial position.
“Some people may look and feel wealthy but they aren’t really looking at their net position. They are looking at their assets and go, ‘Look how wealthy I am.’ They are aware they’ve got borrowings and a mortgage but don’t necessarily appreciate the full extent of what their net position is. “If an adviser is doing a proper job it can put someone on a more accurate path to prosperity than just saying, ‘Let’s invest your money here and what sort of risks are you prepared to take.’
“It comes back to the original question about how important your net position is because if you don’t have an accurate picture of where you are now, your starting line isn’t even correct,” says Lewis.
People frequently underestimate living expenses. This is especially apparent (and more critical) when discussing retirement funding with those aged 45-plus.
“The real reality check is how much people think it’s going to cost them in retirement. They totally underestimate it.
“They also overestimate government benefits. Given 80% of folks are on some form of age pension, if you ask somebody over 50 what do you think the age pension is, nine times out of 10 they will be totally wrong and nine times out of 10 it’s overstated.
“Hopefully you’ve got a self-funded retiree who doesn’t need to worry about this but what I’m getting at is, ‘Well what’s your position going to look like? How much are you going to need and then let’s work out how much capital you need to have at retirement.’ That’s where your net position comes into play. You’re 45 now, you have X amount and you need Y at retirement, that’s what you should be aiming for and funding between now and retirement.”
“There’s a lot of misconceptions about what constitutes real wealth and whether people are wealthy or not,” says Hutton. “There’s an element with some people if they have a $3 million house, they deserve to have a new car and new furniture. Just because the bank gives you the money to buy or lease the car doesn’t mean it’s a good financial decision to do it.”
Another misconception, he says, is the belief that property is as safe as houses, and that bricks and mortar can’t go down.
“There are times when property goes sideways for a long time, and it does go down and can go down quite dramatically depending on the property. You can find a situation where you live with a fair chunk of debt and not so much value in property.”
But one of the worst misconceptions, Hutton says, is thinking a high income equals wealth.
“People might have a high income and they think they are pretty wealthy and they can afford this and they can afford that but the reality is they are just spending all of their income, or maybe even more than it and relying on borrowings, and that’s not a good way of generating good long-term wealth.”
Some attribute the buy-now-pay-later approach to a kind of blind optimism.
Referring to a recent report by the Financial Planning Association called Dare to Dream, Raftery says that when Gen Ys were asked if there would be another global financial crisis in their lifetime only 15% said yes.
“Now you know and I know there are economic downturns every 15 to 20 years or so. We’ve had the oil crisis, a recession in the early ’90s, the global tech bubble, property bubbles and the GFC. We don’t know when it’s going to be but we know it will happen again.”
Despite that we’ve learnt little from the GFC as individuals and as a country.
“We’re in a weaker position now because we didn’t learn any lessons from the GFC. When you have government on both sides spending more than they bring in, some people say, ‘Why should I be frugal? Why save money? Things will be good down the track. We’ll be looked after.’ ”
So part of getting real is not biting off more than you can chew, and looking at the downside risks: how would you cope if interest rates kept climbing, or you lost your job or couldn’t work due to ill health?
“If you’re buying a property you should have a 30% deposit on top of the 5%-10% you need to cover transaction costs like stamp duties and legal fees,” says Raftery. “That creates a buffer so if there is a market downturn you don’t have to sell the property.
“Do a buffer test. What if interest rates go to 11%? Can you make principal as well as interest repayments? If you have a $50,000 mortgage and interest goes up to 11% it’s not a worry. If you’ve got a $1 million debt and interest rates go up to 11% all of sudden you are in a tough situation.”
As a chartered accountant he admits he is financially conservative and suggests you should insulate yourself from shocks as much as you can.
“Nothing is always rosy. The reality is that we will probably, at some stage, be made redundant because of an economic downturn, or our income won’t be increasing or you might not get a bonus.
“Basically you should save enough cash to pay for six months worth of commitments – all your living costs and monthly repayments. How many people can honestly say they have that sitting in their bank account right now?”
Then there is the question of making yourself fireproof – that is, being work smart.
“It’s a competitive jobs market. Have a look at your CV. Do you have a master’s degree as well as a bachelor’s degree? Have you done extra training courses? Are you multi-skilled? If not, upskill yourself. You don’t want to be in the position that you are a disposable commodity. Make yourself invaluable so your boss wants to keep you on no matter what.”
Looking at downside risks doesn’t mean you should neglect investing or contributing more to super.
“The way to build enduring wealth is to spend less than you earn, save the difference, and do something meaningful with the money saved. This could include making extra repayments on the mortgage or making regular deposits to an investment portfolio.
“We focus a lot on regular savings plans, putting money away on a regular basis into a good-quality investment portfolio that’s diversified, not too risky, and that’s tax effective. Over time it’s surprising how that accumulates and strengthens your wealth.”
• Does your income exceed your spending?
• Do you save money each month?
• Do you pay the full amount off your credit cards each month?
• Do you have adequate insurance?
• Can you manage an emergency without increasing debt or selling assets?
• Can you cover expenses or loss of income over the next two years?
• Are you investing appropriately for your circumstances?
• Is your portfolio diversified?
• Have you consolidated your super accounts and checked its performance?
• Do you have a will and other estate planning arrangements?
• Are you on track for a comfortable retirement?
“Not being able to repay credit card debt each month is often the first sign that your personal cash flow is in trouble,” warns HLB Mann Judd’s Michael Hutton.
“That is still at 18% interest rate and it’s not deductible.”
He suggests you have a budget, stick to it and track your credit card spending through the month.
“It’s worthwhile keeping an eye on the running total.”