Equity Builder

Want a low risk way to gear up your wealth? Wanna get paid to use other people’s money to invest? Want to borrow money at -1% (yes, minus one percent!) interest? Then read on!

Alright, that may be overdoing it a little. But seriously, NAB’s Equity Builder share investment loan is a nifty product, offering a pretty unique approach to stock gearing in a cosy, relatively safe package. It fills a gap in the gearing market, allowing those without property investments to get their foot in the door. And it really does allow you to positively gear your investments, with a lower interest rate than the expected dividend yields, so it does kind of feel like a negative interest rate.

What is the Equity Builder?

Equity Builder is a relatively new type of investment loan, started a couple of years ago by the National Australia Bank. It’s sort of a hybrid, a cross between a house mortgage and a stock margin loan. Like a home loan, it’s a Principal & Interest loan, secured against your assets. Like a margin loan, it allows you to invest in the share market. Unlike a margin loan, you don’t have to worry about margin calls if your shares drop in value. It has a variable interest rate of 5.05% per year, and usually has a duration of 10 to 15 years, although this is flexible and there’s no penalty for closing out the loan early. You can use either cash or your existing shares as the deposit to secure the loan. It has a fairly conservative maximum Loan Value Ratio of around 70% to 75%, although this varies slightly depending on which shares you use it to invest in. The biggest limitation is the very short list of shares which you can buy with the money you borrow: you can only invest in large, diversified funds, including most of the big name ETFs, LICs, and managed funds. Luckily for me, almost everything I’d be interested in buying right now is on the list anyway, including VAS, VGS, AFIC, Argo and Milton. You can see the full list of approved investments here, but first you have to click that over to the Equity Builder list.

Once your loan facility has been approved, you need to send NAB a request for them to purchase shares on your behalf. The shares will then be held in trust by NAB’s nominee for the duration of the loan, although all entitlements and dividends associated with those shares go directly to you. After you send them your request to purchase shares, it takes about a week for them to process the purchase, and when they finally do hit the button, the purchase will go through at the current market rates of that day. This means that you can’t target a specific share price, so there’s no point trying to use it for short term trading, since it’s not agile enough to profit from volatility. Your mindset has to be sufficiently long term to not care about short term price fluctuations.

It’s important to note that moving shares into the loan to pay the deposit is not considered a capital gains event.  Moving the shares back into your own personal name at the end isn’t either.  So you’re never forced to pay capital gains tax along the way.  (Unless you decide to sell some of your shares, of course.)

What is it good for?

Despite the limitations, it’s surprisingly versatile. You don’t need to borrow the whole amount in one go, you can apply for a larger amount and spend it in smaller portions whenever you’re ready. If you pay the principal down ahead of schedule, you can re-draw from the difference later on to buy more shares. There are no fees, aside from the interest on the amount you’ve actually borrowed, so you can even use it as a source of dry powder, keeping the funds available for free until you’re ready to deploy them.

The Equity Builder is a great way to save money on brokerage. I often see people online looking for ways to save brokerage on frequent, small share purchases. It’s usually in the context of comparing Vanguard’s ETFs versus managed funds, where ETFs have cheaper ongoing fees, but the managed funds allow free deposits. If you’re the kind of person who wants to make small weekly or monthly deposits into your share holdings, but you don’t want to pay a premium on management fees, then buy cheap ETFs or LICs through the Equity Builder, and make as many repayments as you like. It effectively rolls all of your small transactions into a single up-front $14.95 brokerage fee.

The Equity Builder has gotten some good press from pundits far more knowledgeable than I. The financial product comparison service, Canstar, gave it an award for innovation, for filling a gap in the investment market for investors looking to own shares outright without leveraging real estate equity. Noel Whittaker, author of Borrowing to Invest (which I recently reviewed) , wrote glowing praise of the Equity Builder, for making stock investing more accessible to a broader audience.

Apples and oranges

To properly understand the Equity Builder, we need to compare it with similar products. If you’re looking to gear into stocks, then your options are somewhat limited. The most obvious comparison is with margin loans. Most brokers offer margin loans, at varying interest rates, but all the ones I’ve seen have worse interest rates than the Equity Builder. The biggest drawback with these is the threat of getting a margin call; if your Loan Value Ratio (LVR) goes above a certain limit, then the bank will suddenly demand that you pay the difference to bring your LVR back into line, or else they will sell your investment at the worst possible time. This could be caused by a shudder in the market, decreasing the value of your investment, which is something you have no control of. You can manage this risk by paying down your principal to maintain a safe LVR, but you never really know how sharply your shares could drop in price, so the risk is always there.

In contrast with this, the Equity Builder proudly proclaims that it doesn’t do margin calls, so you don’t need to worry about volatility in your stock prices. However, margin loans are typically Interest Only, whereas with the Equity Builder you have to pay off the Principal & Interest each month, meaning your LVR will be constantly improving anyway. In other words, you’re already doing exactly what you’d have to do to avoid the risk of a margin call in a traditional margin loan, so the end result is not very different. The Equity Builder simply takes the decision out of your hands, by forcing you to play it safe. The compulsory monthly principal repayments also mean that your cash flow will take a hit in real terms, even though it’s positively geared, and the bulk of that cash flow hit will be non-deductible. If that bothers you, then get a margin loan instead. If you were planning to pay off the principal to get that juicy equity into your own hands eventually anyway, then the Equity Builder might be perfect for you.

A major benefit of a margin loan versus the Equity Builder is that you’re not limited to the short list of allowed investments. With the Equity Builder you can only invest in a narrow range of LICs, ETFs, and managed funds, whereas with margin loans you can buy pretty much any stock you want. Bear in mind that if you buy risky stocks, your danger of getting a margin call increases, so most advisors will recommend sticking with staid and steady diversified investments, anyway. But again, if you’re after the freedom to pursue a wide range of options, then this is something to consider.

I’m yet to find a CHESS-sponsored margin loan vendor with a better rate than the Equity Builder, but if you know of one, please feel free to leave a comment below. Here are some numbers, to get to the grist of the comparison: The NAB Equity Builder’s interest rate is a flat 5.05% per annum, regardless of the size or duration of your loan. NAB’s own margin loan facility has interest rates ranging from 5.3% (for loans greater than a million dollars) to 6.55%. Rounding out the big 4 banks: ANZ charges from 6.4% to 7%, Commonwealth is 6.5% – 7.4%, and Westpac (via BT) is 6.6% – 7.6%. You can get better rates at some of the more niche brokers.  Interactive Brokers charges only 3.67%, and even lower if you borrow megabucks, but with these non-CHESS sponsored brokers you don’t actually own the shares you buy through them.

Apart from margin loans, the only other option is equity loans, but for these you need to already own a house. If you have a decent amount of property equity, you can get a line of credit to borrow against that equity. This means that if your investment goes pear shaped, then the bank will recoup their losses by taking your house! The upside, of course, is that you’ll get a much better interest rate, usually the same as your mortgage interest rate, probably somewhere around 3 or 4 percent. Banks will give much better rates for investing in property than shares, so the line of credit gives you the best of both worlds. However, if you don’t happen to have a house lying around, then you’re bang out of luck on this front…

Positive gearing is best gearing!

If you’re aiming for a passive income stream from dividends, and you’re planning to buy good dividend producing LICs or ETFs, then the Equity Builder is a great option. It’s perfectly tailored to investors chasing financial independence. You get to start earning and compounding dividends much quicker than you would if you were waiting to buy chunks of shares using cash. If you use the loan to invest in Australian equities, then the grossed up franked dividends will be paying you more than the interest will cost you, so you’re effectively being paid free money to invest earlier than you could otherwise! If you don’t believe me, here are some numbers to crunch:

Let’s say you borrow some money and use it to buy shares in Milton (ASX:MLT). I’m not spruiking Milton here, I just picked it because it has a stable dividend history. Milton is currently trading at roughly $4.50, and in the past 12 months it paid 19.2 cents per share in dividends, fully franked. (Remember that Milton has been consistently increasing its dividends faster than inflation for the last 60 years, so, realistically, I don’t see anything threatening that income stream.) That’s a net dividend yield of 4.3%. When you factor in the 100% franking credits on the dividends, that gives you a grossed up annual yield of 6.1% and rising. The Equity Builder loan will cost you 5.05% per annum, so you’re banking the leftover 1.05%. This is what I mean by negative interest, it really is like the interest rate is -1.05%! But it gets even better: the cherry on top is the tax deduction that you’ll get for the interest payments. That pushes the upside even higher, depending on your marginal tax rate.

If that seems too good to be true, then that’s only because the Equity Builder is aimed at a somewhat narrow audience. It’s not for everyone. But if you’re like me, intent on building a portfolio of equities to produce a growing passive income stream, then this is a no-brainer on a silver platter. Get amongst it!

Not your cup of tea?

If you already have a house, then you’re not really the right target audience, and you’d probably be better off getting a line of credit secured against your home equity, then using that to purchase dividend producing shares. (Which would allow you to recycle your debt to turn your non-deductible home mortgage interest into an investment tax deduction!)

Equity Builder is a Principal & Interest loan, so don’t view it as a typical speculative leverage play. It’s not designed for short term trading, and you probably wouldn’t want to use it if you’re hoping to flip shares for capital growth. Use it to buy shares that you’d want to hold long-term and would buy eventually anyway. If you’re looking for the maximum you can borrow, to the limit of the debt that you can afford to service each month, then an Interest Only (IO) loan would allow you to leverage on a much larger scale, with less impact on your cash flow. However, that basically limits you to real estate. I don’t have a lazy couple of hundred grand lying around, so for me real estate isn’t an option.

The Equity Builder does actually give you the choice to turn it into an Interest Only loan, but only for extremely low lending ratios. Once you get your LVR down to 30%, they allow you to suspend the principal repayments indefinitely. At that point the serviceability shoots up dramatically, so you could let the dividends pay the interest and reinvest the leftovers, then just sit back and watch your investment grow forever and a day. You could even borrow only 30% to start with and run the facility as IO from the start, but if that’s your game, then again, you’d probably be better off in real estate.

The personal touch

My experience with the Equity Builder so far has been extremely positive. In July 2018 I started a modest loan of $20,000, and then a month later we got another one in my wife’s name for a further $10,000. Small potatoes to get our toes moist. For both of our loans, we used shares we already owned as our deposits, rather than cash. That was a simple process of sending them a form telling them to transfer the shares out of our personal shareholding accounts and into the hands of their nominee, who holds them for the duration of the loan. We spent the $30K we borrowed on equal chunks of Milton (ASX:MLT), Vanguard’s Australian Shares Index ETF (ASX:VAS), and Vanguard’s International ETF (ASX:VGS). NAB were fast to respond to all my questions, they gave me clear but thorough answers, and it was easy to reach them by phone for further clarification when required. The process of setting up the loan and investing through it was quick and painless. The website interface was adequate, although not flashy, and not as smooth as it could have been, but personally I don’t need any bells and whistles on my investment products. The only mild frustration was waiting for the shares to be purchased at the start, watching the markets bob up and down without knowing exactly when the purchase would go through. But, as I said before, this loan really just encourages a long term outlook.

We structured both our loans with maximum duration of 3 years, but we’re way ahead of that schedule. We’ve made additional repayments every month, in part because it’s handy to be able to throw small amounts into the market on a regular basis without paying brokerage, and also because the guaranteed 5% return (on interest saved) looked better than the overall share market during the past few months. We paid off my wife’s loan very quickly, since she gets less benefit from the tax deductible interest than I do (since she’s on a lower marginal tax rate), and we finished paying it down last week. As soon as we made the last payment, we sent NAB a request to transfer her shares from the nominee into her personal shareholding account, and it only took a couple of days for them to be transferred, no questions asked. We’ll probably close her loan facility shortly, a simple and cost free process. The loan in my name is now down to below 30% LVR, so I could switch it over to Interest Only, except that I prefer to keep reducing the Principal anyway.

I wrote about this loan in my financial plan a little while ago, and I’m quite pleased with how it’s been going in that context. It’s helped us to build up our portfolios a little quicker than we could have if we’d been saving cash in the bank to make share purchases with. Most importantly, it’s given us a first taste of how leverage can function, and taught us that debt is something to be cautious about, but not afraid of. Towards our longer term plan, it’s given us a larger base of stock equity to use as a deposit for the next, larger, gearing package, while also increasing our passive cash flow to help us service the next chunk of debt. I’m calling it now; this experiment has been a resounding success.

The Infinitesimals

I’ve discussed the Equity Builder with several other investors online, and a common query I hear is “Isn’t this actually just a margin loan in disguise?” Even though the Equity Builder claims to eliminate the risk of margin calls associated with more mainstream stock loans, there are a few other risks involved. There’s a risk that the list of approved shares could change, and if the shares you’ve invested in get removed, or have their minimum LVRs changed to higher than your LVR, then NAB reserves the right to sell your investments, which carries the risk of unwanted capital gains tax liability. The approved shares are chosen for the list based on their size and liquidity, so, in the event of a serious market crash then it’s possible that even the big old LICs and ETFs might get disqualified. However, it would have to be a truly cataclysmic event, which would also hit all the alternative gearing options. This is significantly different from a margin loan, where something as simple as normal price fluctuations can push your loan into the danger zone. The Equity Builder is a whole lot more secure than that.

There’s also a risk that the variable interest rate could rise, and indeed it did just a few months ago. When I started using it, the rate was only 4.95%, but it went up 0.1% late last year. It didn’t bother me because it’s still well below the dividend yields I’m getting from it. And of course, as always, there’s the ever present risk that your investments could decline in value, and this loss would be amplified by the gearing. So do your homework, make informed decisions, and always borrow less than you can afford.

Disclaimer:
I’m not affiliated with NAB in any way, apart from owning a few of their shares. I don’t stand to gain financially from you deciding to invest with them. Nothing written above should be taken as personal financial advice, I’m not a qualified accountant or advisor. Do your own research, your mileage may vary, etc etc etc.