Gearing
Background
Borrowing for investment purposes is also known as ‘gearing’. Gearing is generally only appropriate for investors with a growth orientated risk profile and are looking into investing in growth orientated assets such as shares and property. Due to the greater level of market volatility associated with growth assets, gearing should only be considered a long-term strategy (time horizon of at least 7 years).
Types of gearing
There are 3 different types of gearing:
- Negative gearing: where the interest payable on borrowed funds exceeds income received from the investment. The investor must have surplus income from other sources to meet the shortfall
- Positive gearing: where the expenses incurred in relation to the investment are less than the income generated
- Neutral gearing: where the costs of the loan are approximately the same as the income generated
Benefits
- Borrow gives you more money to invest which may provide greater potential to diversify and buy larger assets such as property
- Can allow you to build wealth faster
- Interest and related borrowing costs are usually tax-deductible if the loan is used to acquire an income producing asset.
Warnings
- It is important to remember that while investing more money provides more opportunities for capital gains, it can also lead to losses if the market does not perform well. In other words, gearing magnifies not only investment returns, but also magnifies losses.
- Tax advantages from negative gearing should not be the sole reason for establishing a gearing strategy
- You should ensure your employment and cash flow are secure, so you aren’t forced to sell down your investment portfolio if markets aren’t performing well
- You must consider a possible rise in interest rates or reduction in dividends or rental income from the investment and ensure there is sufficient cash flow to absorb these effects.
- Legislation may change in the future in relation to the tax deductibility of interest payments