Borrowing to Invest.
Borrowing, or gearing, can help you accelerate your wealth creation. It can allow you to buy assets such as an investment property, or shares that you may not be able to afford outright.
By borrowing money to invest, you could potentially multiply your investment profits and achieve your wealth goals sooner. Note however that there is a downside in that it can increase your losses if your investments fall in value.
Investment loans and Margin loans
Many people borrow to invest in a property, through an investment property loan, or in shares either through an investment loan or a margin loan. An investment loan is generally secured against property and a margin loan is secured against shares and managed funds. Each carries their own benefits and risks and to be successful in the long term, the investments you acquire with borrowed money must generate a total return (income and capital growth) that exceeds the after-tax costs of financing the investment (including interest on the loan).
Negative or positive gearing
If you are thinking about borrowing to invest you need to understand if the investment will be negatively or positively geared.
Negative gearing is when your income from an investment (such as dividends or rental income) is less than your interest and/or other expenses. If you negatively gear your investment is initially making a loss which you hope you will make up with a capital gain when you sell your investment.
A loss can be used to reduce your taxable income which will reduce the amount of tax you pay. Remember, you are only reducing your tax because the income from your investment isn’t covering your expenses. You will still need to cover the negative cash flow from other sources.
Positive gearing is where your income from an investment is higher than your interest and/or other expenses. This means you will have extra money in your budget but you will have to pay tax on the additional net income.
Case study: Bruce’s geared investment
Bruce has a geared investment that has cost $10,000 in interest this year and has returned $7,000 in income from dividends this year. He is negatively geared as his investment is producing a loss of $3,000 per year. He can deduct this $3,000 from his taxable income. If Bruce pays tax on his salary at 39%, he can reduce his tax bill by $1,170 (39% of $3,000).
This may be reducing his tax but it is still costing Bruce money. For the investment to work for Bruce this loss, and any losses in future years, will need to be offset by a capital gain (after tax) when Bruce sells it, in order to achieve an overall positive return.
If the investment decreases in value, Bruce will have lost some of his capital as well as having paid expenses along the way, giving him a negative return on his investment.
If you are borrowing to invest it’s important to make sure your investments are diversified. Diversification will reduce your investment risk and leave you less exposed to a single economic event, so if one business or sector you’ve invested in fails or performs poorly, you won’t lose all your money.
The less diversified your investments the higher the risk. It is risky to borrow to invest in one company, one property or one industry sector.
As you can see, this investment approach doesn’t suit everyone, so before you act, discuss your situation, goals and objectives with a licensed financial adviser.
Get in touch with us for more information.
For your reference: ASIC’s Money Smart Website
This communication has been prepared on a general advice basis only. The information has not been prepared to take into account your specific objectives, needs and financial situation. The information may not be appropriate to your individual needs and you should seek advice from your financial adviser before making any investment decisions.