Many of us have borrowed money at one time or another for our larger purchases, like a holiday or a car. However, when done sensibly and with careful planning there are cases when borrowing to invest can be even more worthwhile.
What is Gearing?
Gearing is another term for borrowing to invest. It is a sophisticated investment technique and is not suitable for everyone.
Positive or Negative
Positive gearing is when the interest payments and other investment costs are lower than the income you receive from the investment.
Example of Positive Gearing
Borrowing to invest in shares when the dividend income exceeds the expenses of the loan.
Negative Gearing is when the interest payments and other investment costs are higher than the income you receive from the investment.
Example of Negative Gearing
Negative gearing on a rental property occurs when the interest payable on the loan used to purchase the property plus other expenses (maintenance, etc) exceeds the rental income generated by the property.
The benefits and risks of gearing
Like all investment strategies, there are some risks associated with gearing.
- Gearing can be attractive because under current Australian taxation laws, you may be able to claim a deduction for interest and expenses, which can be offset against assessable income, such as salary, business income or investment income.
- Gearing allows you to increase your ability to create wealth by enabling a higher level of investment than would otherwise be possible. In a favourable market your earning potential can be multiplied.
- If you choose to invest your geared funds into selected shares, the dividend imputation system (DIS) will result in you receiving a tax credit on the dividends you collect (known as 'franked dividends') and, therefore, you are accountable for only a small amount of tax on this income. This can actually have a positive effect on your cash flow.
- Assets may not always provide the returns you expect. You should only borrow to invest if you expect the investment itself will be producing genuine, decent returns somewhere down the track.
- If you over-extend your borrowing, rising interest rates could restrict your ability to meet loan repayments.
- There may be periods where your investment provides little or no income, or even losses.
- Gearing can multiply your losses.
- Should you wish to sell a geared asset and pay off your loan earlier than expected, penalties may apply.
- You may be forced to sell in an unfavourable market
Still not sure whether Gearing is right for you as part of your investment strategy? It's never a bad idea to reach out for some expert help.
The Greater has partnered with Bridges to provide industry-leading Financial Planning to customers. Bridges can help with Investment Planning, Retirement Planning, Superannuation, Life Insurance and so much more.
Why not speak to a Bridges Financial Planner and see what they can do for you?
If you found this blog helpful, be sure to connect with us on Facebook, Twitter and Google + for regularly updated content.