Gearing can be an effective and tax-efficient way of building your investments over the long-term. While it can increase your investment returns, you should be aware of the risks involved.
What is gearing?
Gearing is the strategy of borrowing money to invest. Just as you take out a loan to buy a home, you can also borrow money to invest in other assets, such as shares, property or managed funds.
Gearing enables you to boost your investment earning power by increasing the amount of money you have available to invest. While investing with someone else’s money sounds like a great strategy (and it can be), there are risks involved – so it’s not suitable for everyone.
Generally, to be effective a geared investment should:
- generate a reliable long-term income flow
- generate income that grows throughout the investment timeframe and becomes positively geared
- generate capital gains, ie. an increase in the value of your investments over time
- be highly diversified with a number of individual investments
- be considered for investment time frames of five years or more
- draw on stable and reliable cash flows to meet the pre-tax borrowing costs.
Who is gearing appropriate for?
Implementing a geared investment strategy is a long term commitment, suitable for investors with time horizons of five years or more. This allows enough time for you to benefit from the returns of growth assets and to ride out any short-term market fluctuations.
If you are considering gearing, you will need to ensure you have sufficient excess disposable income to service your loan repayments and to cope with an increase in your loan repayments if interest rates were to rise.
What are the benefits and risks?
The main benefit of this strategy is that the amount you have available to invest is increased by the amount you have borrowed, so you earn investment returns on a larger amount. Depending on your circumstances, there may also be tax advantages associated with this type of investment.
The benefits of gearing include:
- larger returns if your investment increases in value
- increased amount of money you have to invest
- potential tax advantages
- you can achieve higher returns (after costs) than you could without borrowing.
The risks of gearing include:
- larger losses if your investment decreases in value
- if interest rates go up, you may not be able to meet your interest repayments
- net returns must be higher than your net interest costs for this strategy to be beneficial.
Positive, neutral and negative gearing
Gearing may be classified into three levels – positive, neutral and negative. The category your geared investment falls into is determined by how much interest you pay on the loan, compared with how much income your investment earns.
For example, let’s say you invest $150,000 in a managed fund, of which $50,000 is borrowed. The interest on your loan is 8% pa or $4,000 in repayments.
If the managed fund produces income of $4,500, you will achieve a net cash flow gain of $500.
If the managed fund produces income of $4,000, there is no net cash flow gain or loss.
If the managed fund produces income of $3,500, you’ll see a net cash flow loss of $500.
Repaying your gearing loan
If you use gearing as part of your financial strategy, at some point the loan capital and interest will need to be repaid. The three main options for repaying your loan are:
- selling off a portion of your investments
- establishing a separate savings account to accumulate the loan capital
- paying out the loan capital over the term of the loan.
If you have any questions regarding gearing, or would like to know how you could use it to your advantage, please give us a call on 03 5434 7600.