Provided by Mercer: 29/6/09
By borrowing money, an investor may be able to invest more than they could on the basis of using their own money alone. Gearing generally refers to borrowing to invest.
Here we look at a range of issues associated with borrowing to invest, including the different types of gearing, risks and other issues you should keep in mind, how to gear your investments and how you might use this strategy to your advantage given the current financial environment.
There are different types of gearing
When talk turns to borrowing to invest, it generally tends to be in the context of negative gearing. Negative gearing refers to a situation where the cost of borrowing exceeds the return; the advantage of this type of strategy is that the borrower may be able to gain a tax benefit by offsetting the loss against their assessable income. That is, a tax deduction on the value of the loss. However, not all effective gearing strategies are negative and positive and neutral gearing strategies are also used by investors to further their financial goals.
Positive gearing means that the returns outstrip the cost of borrowing. So, any returns earned by the investor exceed the cost of interest and fees associated with borrowing. Neutral gearing is exactly as the name implies – the returns earned on the geared investment are equal to the cost of borrowing. Neutral gearing is generally used as a risk management strategy, particularly during periods of economic and financial uncertainty.
Different types of investments can be geared
Many different types of investments can be geared and a range of products exists to help you gear your investments. In many cases it’s something that can be done without purchasing a geared financial product. A common example of a geared investment is buying an investment property. You’ll borrow money from the bank to purchase the property and then aim to make a return through rental returns or by selling the property or both. Investments into shares or managed funds can be geared by borrowing from a bank or via the use of a margin lending facility. Some fund managers also offer geared share funds which are geared by the fund manager based on assets already owned by that fund.
Is now the time to consider a gearing strategy?
It seems counterintuitive to borrow money to invest at a time when investment and property markets are low and volatile and the world economic situation is gloomy. However, there are a few features of the current environment that may favour a geared strategy. For instance, interest rates are low. This means that the cost of borrowing is fairly cheap in comparison to other times when interest rates have been higher. Some assets are also cheaper which means that using the buying power of your existing funds improved by the money you’ve borrowed, you can afford to buy more of a cheaper asset, though you have to evaluate its value. For example if share prices are low you have more buying power. Don’t forget to consider whether the underlying investment is suitable for your needs as a cheaper investment is not necessarily a good one.
You’ll need a higher risk tolerance to engage in a geared strategy
There are risks involved in a geared investment strategy. Whilst returns are magnified, the potential for loss is greatly increased because if the value of the investment falls, you’ve not only made a negative return, you also have to pay back the loan. When undertaking a geared investment strategy, it’s important to ensure you have a secure cash flow so that you can cover your borrowings if the value of your investment falls. It’s equally important to have adequate personal insurance as well as a tolerance for risk. Gearing an investment increases its volatility substantially and you must be able to tolerate significant ups and downs over the course of your investment horizon, in pursuit of your investment goals.
You don’t need to do it alone
Given the risks of a geared investment, it’s important to determine whether it suits your personal circumstances, risk profile and financial situation. A licensed, or appropriately authorised, financial adviser can help you determine whether a geared strategy suits you and how you might go about it in a way that suits your financial situation. They can also help you work out whether you can structure it outside of an existing product or help you work out which product best suits your needs. Borrowing to invest may be a useful and effective strategy but it’s not for everyone so take the time to ensure you’re informed about its risks and advantages.
More information
If you would like to discuss your investment strategy with a Mercer financial adviser, please call 1800 633 403.
This information has been prepared by Mercer (Australia) Pty Ltd ABN 32 005 315 917 for general information only. The information does not take into account your personal objectives, financial situation or needs. Therefore, you should not act on this information if you have not considered the appropriateness of this information to your personal objectives, financial situation and needs. You should consult a licensed or appropriately authorised financial adviser before making any investment decision.
