The Insider – Shortcomings of 100% Investment Lending into Capital Protected Products

Having worked within the financial services landscape for many years, The Insider provides investors with a behind the scenes view on the financial services industry

I was recently asked to look at a protected product for a friend of mine; an adviser had recommended he take out a 100% loan ($800,000) and invest in two protected products with a 7 year term in 2008. The view at the time was that since it was a protected product, his worst case scenario was that he would simply receive his money back. He considered that it a punt, but with an annual interest bill of just under 10%, it was worth it as he could always just cash in the investments if the markets didn’t perform as expected since it was a protected investment and all he would have lost was the interest he had paid.

Unfortunately, this is not the case. What he had failed to understand (and is clear that his adviser had also not understood) was that the protection only applies at maturity.

Rules to investing with 100% investment loans

Do the numbers stack up – If you are borrowing at say 9% pa, then you need a return of 9% pa to break even. If you don’t think this is realistic, don’t invest.

Don’t get caught in the trap of thinking it’s a tax deduction – You still pay tax if you make a profit, it’s therefore better to think of structured products as providing tax deferral.

Steer clear of fixed interest options – Fixing your interest rate is often seen as a way of reducing the risk of rising interest rates. My view is if you can’t afford interest rates to rise, then you can’t afford the investment. Fixing your rate often means paying a premium on the interest rate and typically has a high break cost. You are simply locking in a profit margin for the loan provider.

Flexibility is king – Unlike home loans, investment loans generally mean that your are tied to the same provider until maturity and are often at the mercy of the rates offered by the product provider.

If you are concerned rates my rise, look for a product with a Walk-Away feature, that way, if the interest becomes unaffordable or the investment falls in value, you can simply Walk-Away.

In the meantime, he has to continue to paying the interest and what he thought was a punt at 10% was actually a commitment to pay the 10% pa until maturity where his protection would repay his loan. This means he has paid 70% over the 7 years of his investments less the tax deduction on the interest.

There’s no point me saying, “The lesson to be learned is ….he should have read the PDS, …. he should of diversified, ….. he shouldn’t of gambled”. In 2008 I distinctly remember questioning one of the sales reps from the companies offering these products as to how their protection mechanism worked. The response I received was “Who cares, it’s protected, that’s all you need to know”.

There was simply a lack of knowledge as to how these products were protected. There was a common misconception among both investors and advisers that you paid an ongoing fee for protection and if the fund fell in value, you could cash it in and get your money back. Many, to their financial detriment, now know the harsh reality.

The changing landscape benefits new investors

Post GFC, advisers and investors can now draw on personal experience that investment markets do 1 in 20 year worst case scenarios seem to be ever more prevalent has forced these products to evolve, providing investors with greater freedom and choice:

Many products now offer the flexibility to “Walk-Away” each year without penalty if the investment is below the starting value. This provides flexibility to break your current terms without a financial consequence and the option to reinvest if you desire at a lower level.

By far the worst advice I have seen with these products are investors tied into high fixed rate interest loans. With best case returns of around 10%-11%, investors were advised to take a fixed interest loan at a cost of around 10%-11% pa. Not only were they unlikely to ever see a return, but if they tried to cash in early, they would be breaking the loan agreement, regularly resulting in costs of up to 30%.

The new products offering a Walk-Away feature generally means that there is no need for costly fixed interest loans. If interest rates rise and become too costly, you can just “Walk-Away”.

I welcome the evolution of the protected product and with the “Walk-Away” feature my friend would not be nursing a $560,000 financial loss. In fact, had he been able to “Walk-Away” and reset with a new investment at a lower level, he would already be benefiting from the lower interest rates currently offered and be participating in the market recovery.

With the “Walk-Away” feature also allowing SMSFs to borrow and invest, flexible capital protected investments and loans are likely to be here to stay.