Gearing is the strategy of borrowing money to invest. Just as you take out a loan to buy a home, you can also borrow money to invest in other assets, such as shares, property or managed funds.
Gearing enables you to boost your investment earning power by increasing the amount of money you have available to invest. While investing with someone else’s money sounds like a great strategy (and it can be), there are risks involved – so it’s not suitable for everyone.
Generally, to be effective a geared investment should:
- generate a reliable long-term income flow
- generate income that grows throughout the investment timeframe and becomes positively geared
- generate capital gains, ie. an increase in the value of your investments over time
- be highly diversified with a number of individual investments
- be considered for investment time frames of five years or more aa draw on stable and reliable cash flows to meet the pre-tax borrowing costs.
Who is gearing appropriate for?
Implementing a geared investment strategy is a long term commitment, suitable for investors with time horizons of five years or more. This allows enough time for you to benefit from the returns of growth assets and to ride out any short-term market fluctuations. If you are considering gearing, you will need to ensure you have sufficient excess disposable income to service your loan repayments and to cope with an increase in your loan repayments if interest rates were to rise (allowing for a 1.5% increase in rates is probably a safe buffer).
You should also consider taking out sufficient income protection, life, trauma, and total and permanent disability insurance so that if you are unable to work due to accident or illness, you or your dependants can either continue to service your loan repayments or the loan can be repaid in full.
What are the benefits and risks?
The main benefit of this strategy is that the amount you have available to invest is increased by the amount you have borrowed, so you earn investment returns on a larger amount. Depending on your circumstances, there may also be tax advantages associated with this type of investment.
Borrowing to invest is a sophisticated strategy and is not suitable for everyone. The main risk is that by increasing the amount you have invested, you increase your potential losses. If your investments perform poorly, you may be left paying off a loan that is larger than the value of your investments.
The table below summarises the main benefits and risks associated with borrowing money to invest or gearing.
There are three main ways you can generate the capital required to gear your investments.
Home equity gearing
Home equity gearing is borrowing against the existing equity in your home. This allows you to release capital tied up in your home and use it to finance income-producing investments.
You can establish a home equity loan by setting up a redraw facility within your existing home mortgage or by arranging an additional line of credit. These types of lending arrangements offer flexible loan and interest repayment options.
A margin loan allows you to borrow up to a set percentage value (typically 50% to 70%) of selected shares and/or managed funds. The initial investment can comprise cash, approved securities such as shares and managed funds, property, or a combination of these.
Geared unit trust
Unlike other managed funds, with a geared unit trust (also known as a geared managed fund), the product manager uses the assets held within the unit trust as security for borrowing. The trust is then geared at a pre-determined level and the fund manager is responsible for all issues surrounding the borrowing. If you invest in a geared unit trust, your liability will be limited only to the amount you have invested with the trust.
For more information about Gearing contact Rowland Advisory
The importance of financial advice
Gearing can be a highly risky strategy so it makes sense to get professional advice upfront. Here are some ways your financial adviser can help:
Contact Rowland Financial Advisory for more information.