Both tactics can generate above-average returns for an investor so it may seem like a favourable approach to investing. Before considering gearing strategies, however, investors need to understand how they work and what risks they open up.
What is gearing?
Gearing strategies are commonly used by property investors, but some shareholders also practice it.
Gearing and property
Investors may choose to employ a positive, neutral or negative gearing strategy for their property. What differentiates the three is the income and loss they would incur.
- A positively geared property generates income and profit, which are added to the investor’s assessable income in their tax return.
- A neutrally geared property pays for itself because the income generated simply covers loan payments and maintenance costs.
- A negatively geared property incurs a loss because its income is lower than the loan interest payments and related costs. However, investors accept the loss in exchange for income tax offsets.
Gearing and shares
While shares are more volatile in terms of price and value, investors may still negatively gear their shares portfolio by purchasing declining shares. This is also done to take advantage of tax offsets allowed by the Australian Taxation Office (ATO).
How margin loans work
Margin loans allow investors to borrow money from a lender or their broker to buy units of shares or managed funds and use the purchased investments as security. This means if the investor is unable to pay the loan when the lender calls the margin, the lender is legally allowed to sell the shares to repay the loan and interest. However, the borrower must still pay any deficit.
Taking out a margin loan could be a good idea if the investor fully understands how it works and the risks involved.
For example, some experienced investors may take up a margin loan when they try to ‘short’ a company share. They borrow money to purchase the share while its value is low and hold onto them as the share price rallies. Once the increase in value has reached its peak, the investor would sell their shares, pay the margin loan and keep the profits.
However, the opposite can also happen. An inexperienced investor may take up a margin loan to purchase shares that they think are performing well, only for it to actually be a dead cat bounce. If they hold onto the losing shares, they may not only lose the shares and their capital but also sell other assets in their portfolio to pay for the loan.
Risks of investing using borrowed money
Incurring debt to buy investment assets exposes investors to increased risks because investors must still pay the loan amount and interest regardless of the selected asset’s performance.
Some of the biggest risks to consider are:
- Interest rates
- Investment income
Interest rates: Market conditions may drive the lender to increase loan interest rates. This, in turn, could lower the investor’s return on investment or, if negatively geared, increase their financial obligation.
Investment income: The purchased asset may start out profitable, but its value and income-generating capacity could diminish over time, especially when the economy declines.
Capital: If the underlying asset’s value declines and the investor decides to liquidate before the loan is paid, the sale price may not be enough to cover the remaining loan payments and other fees.
There is also the possibility that unforeseen circumstances could result in the loss of income-generating activities, such as employment. When this happens, the investor may find it difficult to pay for the loan but continue to incur interest, thereby pushing them deeper into debt.
Is borrowing to invest a good idea?
Taking out a loan to purchase investment assets can benefit investors because it increases their portfolio’s investment returns when their selected asset increases in value. When this happens, investors can make a profit from the income the asset generates and, upon liquidation, the difference between the purchase and sale prices.
However, borrowing to invest or gearing can also be financially disastrous if market conditions decline.
Borrowing to invest is only a good idea if the market conditions are favourable and the investor understands the investment they are making and risks they are exposed to.
It’s best for investors to discuss any investment that involves a loan with a licensed professional who can advise them of appropriate actions based on their portfolio.
This information has been sourced from ASIC’s Moneysmart and Nest Egg.