Gearing Strategies

Gearing strategies

Most people know what a mortgage is and how it works. It allows someone to purchase something – usually a house – long before they would be able to buy it themselves. By doing this they are effectively earning income from that asset, by not having to pay rent elsewhere, while at the same time benefiting, hopefully, from the long term capital growth achieved from that asset. In return they ‘service that debt by paying interest on the borrowed funds.

Gearing is simply an investment term used when applying the exact same principal, as described above, but where the underlying asset is an investment. It could be a property, a business, direct shares or managed funds.

It can be a powerful means to build wealth. It allows you to increase your ability to build wealth by enabling a higher level of investment than would otherwise be possible. You can either positively gear or negatively gear.

A common gearing vehicle, used primarily for investing in shares and/or managed funds, is a Margin Loan.

Some benefits of gearing include:

Enabling you to undertake a higher level of investment than may otherwise be possible
In favourable market conditions, your earnings can be multiplied
Generally, if the cost of borrowing exceeds the income generated from the investment, this excess may be an allowable tax deduction
If you borrow to invest in shares, or managed funds containing shares, you may obtain imputation credits which can be used to reduce the amount of tax you pay

Many Margin Loans allow you to borrow a modest amount initially and increase this borrowing on a regular basis. This strategy allows you to utilise your regular cash flow to build an investment portfolio over time. This also provides some protection against sudden market movements as you are investing on a regular basis rather than all at once, as you would have to do with a traditional style of loan, such as a mortgage or personal loan.

Any type of gearing has risks, however. These may include:

An asset may not provide the expected return
The market conditions under which you are borrowing may change. If you over-borrow, rising interest rates could restrict your ability to meet the interest payments
If you rely on the income from the investment/s, there may be periods where it produces little or no income, or even losses
Gearing can multiply your losses
If you take out a margin loan, and the market value of your investment falls enough to cause the balance of the loan to exceed the maximum lending value of your portfolio, you will be subject to a margin call