Borrowing to invest
Just as borrowing allows you to buy an asset you may not be able to afford outright, using debt can also be used to buy investments with the potential to grow in value.
This strategy, known as gearing, may help you build an investment portfolio faster than you otherwise could have. To provide you with funds to repay the loan, you’ll have income generated by your investments and possibly some tax deductions.
Therefore for many, servicing an investment loan can be an achievable outcome. The principle behind gearing is that the after tax growth in the value of your investment, plus income, must exceed the after tax cost of borrowing the money to finance the investment – otherwise your investments will be going backwards!
There are also a number of risks that must be borne in mind before deciding to gear. In a market downturn your losses will be magnified as your exposure to investment markets is increased. This can result in unexpected consequences such as being unable to repay the interest or needing to sell down part of an investment.
There are a number of ways you can implement a gearing strategy including:
- Take out a margin loan. This type of loan typically enables you to borrow up to 75% of the value of approved share and unit trust investments. For example, if you have $30,000 and you want to invest in an asset, you may be able to borrow another $70,000 and increase your investment to $100,000. It is also possible to gear on a regular basis, otherwise known as instalment gearing.
- You could invest in an internally geared share fund. These are funds that borrow to leverage an investment in Australian or global shares.
Positive and Negative Gearing
Negative gearing occurs in a situation where the interest repayments (and other costs) on your investment loan are more than the assessable income received from your geared investment. In this case, the cash-flow shortfall can generally be claimed as a tax deduction to offset other sources of assessable income such as a salary or rent.
Alternatively, positive gearing arises when the assessable income from your investments is greater than the interest and other costs you pay on the borrowed money. For example, if you invest $150,000 plus $50,000 of borrowed money at a rate of 6% with a return of 4%, your interest bill will be $3,000 and your investment income will be $8,000, leaving you with a cash flow surplus of $5,000.
Risks
Gearing dramatically increases the risk of investing. Consider the following two factors:
1. Certainty of cashflow
When gearing you need to be able to meet the regular interest costs associated with your borrowings. Do not rely solely on the income from your investments to cover these costs as this income can be unpredictable and interest rates may rise.
To ensure you can meet these costs, you need to be certain that your main source of income (e.g. your salary) is secure and is likely to continue for up to five years as any deficit of income over costs will need to be made up from this regular income.
2. Fall in value of your investments
Although gearing magnifies capital gains, it can also magnify capital losses. If using a margin loan and the ratio of your loan to the value of your investment falls too far, you may be required to pay an amount of your borrowings to bring this ratio back to a more secure level. This is often referred to as a ‘margin call’.
Therefore, when borrowing to invest you should be conscious that markets rise and fall and that you may be required to pay margin calls on your investments.
