Don't underestimate the mathematical power of gearing

It’s stating the obvious to say interest rates are very low at the moment. But what can be easily missed is how powerful low rates can be for investors. And arguably, the next few decades could provide the best opportunities in a lifetime for investors, if they are diligent and invest in high quality assets.When will interest rates rise?That is the million-dollar question. The short answer is that no one really knows. But we should remind ourselves that interest rate expectations can change very quickly, so we must factor that into our investment decision making. That is, make sure you can afford higher loan repayments when rates eventually rise.The RBA has been very firm in regard to its intention. It has said that it will not raise rates until the inflation rate rises above 2% p.a., which it does not expect will occur before 2024. Therefore, it seems variable rates are on hold for at least 2.5 more years.We should consider the level of government indebtedness and the impact rising interest rates will have on the budget. Economies can become reliant on low interested rates – look at Japan as an example. It has been stuck on zero interest rates for more than 20 years.For what it’s worth, my view is that variable rates probably won’t change materially over the next 3 to 5 years. Beyond 5 years, they are likely to rise but probably at a relatively slow pace. It is quite difficult to fathom rates rising above 5-6% p.a. over the next few decades. Low rates could be the “new normal”.Simple math proves its powerInvestors can lock in an interest rate for 5 years at 2.69% p.a. with interest-only repayments. I think we can all agree that is low (especially compared to early 1990’s rates, as shown in this image doing the rounds on social media).Assuming you have a surplus annual cash flow of $25,000 to invest, you have two obvious options:1. Invest it incrementally each year in an investment such as a share market index fund; or2. Borrow a lump sum, buy an investment property and use the cash flow to pay for its net holding costs.If you chose the first option and you received a return of 10% p.a. over the next 20 years (which would be a very good outcome), your investment would be worth almost $1.45 million (equivalent to circa $880k in today’s dollars).If you chose the second option, you could purchase an investment property for $1.2 million. Because fixed interest rates are so low, the cost to hold this investment would be circa $7,000 p.a. after-tax. But you could retain the balance of your surplus cash flow ($25,000 less $7,000 = $18,000) in the loan’s offset account to provide for future interest rate increases. This option would be superior if the value of your investment property appreciated to be worth approximately $2.5 million in 20 years’ time. That equates to a compounding growth rate of only 3.8% p.a.Assuming you buy a high-quality, investment-grade property in a blue-chip location with strong fundamentals, what’s the chance of it appreciating by at least 3.8% p.a.? It’s almost certain, isn’t it?What if property appreciates by 6% p.a.?Continuing with the above example, if the property actually appreciated by 6% p.a., your equity would be worth $2.75 million in 20 years.To achieve the same return using the first option (i.e. no gearing), you would need to generate an average compounding return of at least 15.4% p.a. over 20 years. Historical returns indicate that this tarMy new book is available for pre-order now: Pre-ordering the book will help me get it into bookstores. So please do me a favour - please consider pre-ordering now - links and pre-order bonus are available here: https://prosolution.com.au/book-preorder-bonus Do you have a question for the podcast? Email us at [email protected]. If you're interested in working with our team and me, discover how we can work together here: https://prosolution.com.au/family-office-servicesIf this episode resonated with you, please leave a rating on your favourite podcast platform. Subscribe to my weekly blog: https://prosolution.com.au/stay-connected IMPORTANT: This podcast provides general information about finance, taxes, and credit. This means that the content does not consider your specific objectives, financial situation, or needs. It is crucial for you to assess whether the information is suitable for your circumstances before taking any actions based on it. If you find yourself uncertain about the relevance or your specific needs, it is advisable to seek advice from a licensed and trustworthy professional.