What is gearing?

Gearing is simply borrowing money to invest. The borrowed money can be invested in a number of ways – shares, property, international investment, etc.

Borrowing money to increase your investment can be a way of speeding up your wealth creation, as you have more money working for you. This can have the effect of accelerating your capital gains. Borrowing money to increase your wealth may seem like a contradiction in terms but can be one of the most powerful strategies available for wealth creation.  Also, the strategy can be tax effective.

Gearing in practice

Gearing is generally only worthwhile where the after-tax returns from investment is greater than the after-tax cost of borrowing (eg. loan interest, application fee etc.)

To achieve an investment return that is in excess of the cost of borrowing, an investor is generally relying on capital growth to increase the value of their investment. The likelihood of this occurring over the longer term is greater than over the shorter term.

The investor should also be thinking of investing in growth investments like shares or property. Investing in cash or fixed interest is unlikely to produce returns exceeding the interest costs.

What are the benefits of gearing ?

Leverage – An investor may gain from increased returns on their investment through the process of gearing. By adding borrowed money to you own cash or investment, you increase the sum to be invested. The greater the total value of the investment, the greater the potential for capital gains. This concept is known as ‘leverage’.

Tax deductibility – provided the funds borrowed are used to invest in income producing investments, the interest on that loan is generally tax deductible for the investor.

What types of gearing are there ?

Positive gearing – occurs when the taxable income received from investing (e.g. managed fund, rental property income, or share dividends) is greater than the tax-deductible borrowing cost (e.g. loan, interest, property maintenance costs or ongoing portfolio costs) within a financial year.

Neutral gearing – occurs when the taxable income received from investment is equivalent to the tax-deductible borrowing and investment costs within a financial year.

Negative gearing – occurs when the taxable income received from investing is less than the tax-deductible borrowing and investment cost of the investments.

Because the deductible cost are greater than the investment income, this generally results in excess deductions, which can be claimed against other taxable income received (eg. salary) during the same financial year.

When considering a gearing strategy, an investor should be fully aware of his/her tax position.

Negative gearing is generally most tax-effective for tax payers on the highest marginal rate of tax and is generally less tax-effective for those on lower tax rates or non tax payers. Investors should note that even if they intend to undertake a particular gearing strategy (positive, negative, or neutral) fluctuations in interest rates, investment returns and ongoing costs can impact upon the actual level of gearing achieved.

Gearing reduces the investor’s day to day cash flow

The investor is intentionally making an investment knowing that the income earned from that investment may not cover the ongoing costs involved. The investor should be confident that he or she can afford to fund this cash flow shortfall.

Investment income may be irregular. Share dividends can fluctuate widely. The investor needs to ensure that they have a stable and reliable income from sources other than the investment portfolio and that they are able to meet regular interest payments and other ongoing costs without difficulty.

Gearing in action

Gearing is utilised by investors due to the potential for increased returns on the geared portfolio, however it is important to understand gearing and investing also has the potential to increase losses. This is best illustrated by example.

What are the risks of gearing?

There are risks involved when using gearing as an investment strategy. It is essential to carefully consider these risks and seek investment and taxation advice on your personal situation before implementing a gearing strategy.

Although gearing can magnify your capital gains, it can also magnify your capital losses, even after taking investment advice and making what is considered to be a wise investment, it is possible that the value of the investment/s will fall. It should be remembered that gearing is not a short-term investment strategy and fluctuations in investment values will occur.

If engaging in margin lending, it is possible that you will be asked to pay back some or all of the loan amount borrowed, or to offer additional security, if the investment drops in value. This is known as a margin call.

If engaging in home equity lending, the value of your home is assessed by the lending institution initially to determine the amount to be advanced. The security value of the property again becomes significant if the house is sold or you seek to re-finance. If the value of your property has fallen, It may not be possible to re-finance. Alternatively, a shortfall between the net sale proceeds and the outstanding loan would need to be met by you.

In both cases it is essential that the investor has other funds available should either of these situations occur. The gearing should ideally not need to be unravelled (investment sold) due to unforeseen circumstances, to ensure the appropriate investment time frame is observed.

Other risk involved are:

• The investment may not perform as expected,
• Interest rates may rise,
• Tax regulations may change adversely, and/or
• Your personal or financial circumstances (such as job loss or divorce)may change.

You should consider taking out an income protection insurance policy in case of accident or illness. Income protection insurance may replace up to 75% of the insured’s gross personal exertion income in the event that the insured becomes sick or injured and cannot work for a specified period.

It is equally important to consider taking out life, total and permanent disability and trauma insurance to cover the loan amount and other costs in the event of death, total and permanent disability or suffering a traumatic event. Traumatic events may include heart attack, stroke and some cancers – depending upon the terms of the insurance contract.

Prior to considering a gearing strategy, you should carefully consider your attitude towards loss of capital and the possibility of negative returns, as well as you personal and financial circumstances.