What is gearing?
Gearing is simply borrowing money to invest. The borrowed money can be invested in a number of ways - shares, property, and managed funds.
Borrowing money to increase your investments 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 it is one of the most powerful strategies available for wealth creation. This strategy can also provide you with tax benefits.
When does gearing work?
Over the long term! When the return from investments is less than the cost of maintaining the investment, your investment is negatively geared.
To achieve an investment return that is in excess of the cost of borrowing, an investor is 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. If you are thinking of gearing, you should be willing to maintain your investment for at least five to 10 years.
You should also be thinking of investing in 'growth' investments like shares or property. Investing in cash or fixed interest is highly unlikely to produce the returns you will require.
What are the benefits of gearing?
Leverage - An investor can gain from increased returns through the process of gearing. By adding borrowed money to your own investment funds, 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 benefits - An investor may be able to obtain significant tax concessions through 'negative gearing'. This occurs when:
- an investor borrows money;
- the borrowed money is used to invest in income-producing assets;
- income received from investing is less than the interest payment on the loan.
Investors can claim the excess interest paid on borrowings as a tax deduction. This tax deduction can be claimed against other taxable income received (i.e. salary) during the same year.
What are the risks of gearing?
There are several major risks involved when using gearing as an investment strategy. It is essential to carefully consider these risks, and get investment and taxation advice on your personal situation before starting a gearing strategy. Some potential risks include:
- Reduced cash flow - This is particularly important to consider if you intend to negatively gear an investment. You are intentionally making an investment knowing that the income you earn from that investment will not cover the ongoing costs involved. Make sure you can afford it.
- If possible, you should not be relying solely on the income earned from your investment to meet your regular interest payments. Investment income from property may be irregular and share dividends can fluctuate widely.
- A decrease in the value of your investment - Although gearing can multiply your capital gains, it can also multiply your capital losses. Even after taking investment advice and making what you consider to be a wise investment, it is possible that your investment will fall in value. However it should be remembered that gearing is not a short-term investment strategy and fluctuations in your investment value will occur.
In summary, the main attraction in gearing is the potential to receive higher rates of return on your money than would otherwise be possible without borrowing.