What is Gearing?
Borrowing to invest is gearing. Leveraging into the market can increase the likelihood of building wealth faster. If the purpose of the loan is for investment, the loan interest is tax deductible. This can help reduce your income tax on the investment income.
How does it work?
- Investment loans will be secured by an asset, be that your family home or an investment portfolio.
- Income from the investment can be used to cover the interest expense of the loan. Where the loan interest is higher than the investment income, otherwise known as negative gearing, your personal cash flow will need to support the repayment of the loan.
- Invesment loans tend to be interest only; that is, no repayment of the principal.
When should you do it?
- Your income is stable, and you have adequate cash flow surplus to meet fluctuations in markets and the interest expense of the loan.
- You have a long timeframe for investing, to assist in smoothing out short term volatility in the markets (minimum 7 years).
- You have adequate provisioning for unexpected events and/or flexibility in the gearing strategy to allow for changes to meet these needs in the future.
- You have a high level of risk tolerance to endure market volatility impacting your portfolio.
- You understand the complexities of a gearing strategy and what the pros and cons are.
Margin lending is a type of gearing where the security for the loan is the investment portfolio itself. Margin lending has some unique characteristics that set it apart from more traditional investment lending practices:
- Loan to value ratio (LVR): Each investment, be that a managed fund or listed stock, has its own acceptable limit (%) for borrowing. For example, Westpac Bank ordinary shares might have an LVR of 70% This means you cannot borrow more than 70% of its value.
- Margin calls: If the value of your investment falls below the accepted LVR, even if just for one day, there may be a margin call. Essentially, they will ‘call’ for you to increase the investment contribution so that the LVR falls back within accepted limits. You can meet a margin call in one of three ways:
- Make additional cash payment to pay down the loan value.
- Providing further assets as security.
- Selling down portfolio to meet margin call.
Margin loans are limited recourse meaning that the lender only has claim to the portfolio used as security for settling the debt, not other personal assets.
To manage the risk of a margin call, it is best to keep holding well below the recommended LVR for the security and to keep a well-diversified portfolio to reduce exposure to market volatility in certain sectors and industry. The additional risk of margin lending facilities over other gearing strategies is managing the margin calls. If the portfolio needs to be sold down to repay the loan, it’s often when the market and investment value are low. This crystallises the losses within the portfolio and will reduce the long-term performance of the portfolio.
What are the benefits?
- Borrowing money to increase your investment portfolio gives you increased exposure to investment earnings and capital growth. Your returns are magnified by the loan contribution to your portfolio.
- Investment debt is generally "good debt". You can offset investment income with the interest expense of the loan. Other expenses from your loan and investments may also be tax deductible or capitalise to the investment value, reducing capital gains in the future.
What should I be thinking about?
- Investment income risk: Where the income is less than expected and the loan repayments need to be covered by your personal cash flow.
- Capital risk: Where volatility in the market may result in your asset value being lower than the purchase price. When settling the loan, the proceeds may not cover the principal of the loan and you will need to fund the difference.
- Interest rate risk: Where the loan's interest rate exceed the investment income requiring input from your personal cash flow to make loan repayments.
- Income risk: Where unforeseen changes to your income mean you don’t have adequate income to cover adverse movements in your portfolio that may require input from your personal cash flow.
- Legislative risk: Where the potential for regulatory change negatively impacts the tax advantages of gearing. The government has discussed in recent times, limiting negative gearing strategies and associated tax deductions.
These risks are in addition to the risks associated with investing. Refer to the Investment Risks Knowledge Hub for more information.
- Generally, only certain loans with protection fees in place allow 100% of the investment value to be borrowed. Most will only lend up to a given percentage on the value of the investment.
- Loans require approval. Any recommendations to consolidate or change your debt provisions are subject to approval by your lender.
- Paying out your loan means you will no longer have access to this line of credit.
- There are additional fees for investment loan features. Make sure you understand all the costs for your loan agreement.
- Some loan contracts do not let you access additional repayments once they are made.
- Significant changes to your cash flow such as your wage income, may impact your ability to repay your loan. Seek advice if your experience significant cash flow changes.