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Accumulating wealth using gearing
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Most people are comfortable with borrowing money to buy property, but borrowing to invest in the share market or managed investments can be a better investment decision. Borrowing to invest, also known as Gearing, helps you accumulate wealth faster by investing someone else's money in addition to your own. This is because you benefit from the greater growth of a larger investment.
Although there is a cost to investing borrowed money, if the investment produces a better return than the interest payable on the loan, then you benefit from the difference.
Gearing builds wealth faster - but it isn't for everyone, because there are risks involved. It is for this reason you should seek professional advice.
Gearing can be tax effective
When the interest on the loan is greater than the income you receive from your investment, negative gearing occurs. If you claim that interest as a tax deduction, that tax deduction may be used to reduce your tax on other income, such as your salary. If your investment includes Australian shares, income from your investment is likely to be partly "franked". In other words, tax has already been paid on that income.
Capital gains tax payments are deferred until you sell the investments, enabling you to pay the tax when your marginal tax rate may be lower, such as when you retire.
You also have the option to pre-pay interest on the loan in order to obtain a tax deduction a year earlier.
Understanding the risks
Gearing increases the returns of an investment, whether they be losses or gains. When you gear, you not only multiply your gains in a rising market, but also multiply your losses in a falling market.
At times when investment returns are negative, the value of your investment will fall. If this occurs you may be required to pay back part of the loan or provide extra security by investing more money. This is referred to as a margin call and you are generally required to respond to it within 24 hours.
Other risks include rising interest rates or changing taxation legislation.
How can you manage the risks?
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Invest in a diversified portfolio so that poor performance in one market or share doesn't have a big impact on your total portfolio. |
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Gear at a level lower than the maximum amount allowed by the lender, for example if you geared at 50% versus the maximum of 70%, you would have a buffer against margin calls. |
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Pay the loan interest regularly. This will stop the loan balance and level of gearing from increasing. |
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Reinvest the income from the investment or credit it to the loan. |
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Put some funds aside in the event of a margin call. |
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Monitor your gearing ratio on the loan statements you receive from your lender. |
Is gearing suitable for you?
Taking into account what your financial and lifestyle situation will be over the next five to seven years, are you able to
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Commit to the geared investment throughout that time? |
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Do you have the resolve to ride out falls in investment markets? |
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Do you have a reliable income and expect this to continue for the term of the investment and loan? |
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Do you have an emergency fund to meet potential margin calls? |
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As you can't rely on the returns from your investment to pay the interest on the loan, are you prepared to use some of your income to pay the interest? |
If the answer is yes to all of these questions, then gearing may be appropriate for you.
Investments for gearing
In choosing an investment to gear, conventional wisdom is to prefer Australian share investments. There are, however, investments that can deliver the same level of growth with much less risk. Before making your investment decision you should seek professional financial advice.
How a Financial Planner can assist you?
Your financial planner can meet with you, discuss your financial capacity and tax situation and what you want to achieve.
If gearing is the right strategy for you, they will
• Recommend a monitored investment strategy that will build your wealth while managing risk.
• Establish a strategy with you for dealing with a margin call before one occurs.
• Monitor investment and economic conditions and their impact on your gearing arrangement.
For further information regarding your gearing options, just call us on (08) 8132 9288 in SA or (02) 6286 0517 in ACT/NSW or send us an email
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