Wealth Creation Strategies: Part 4 – Growing Wealth With Gearing

Gearing simply means borrowing money to invest.  Gearing may be used with existing savings to accelerate the process of wealth creation by allowing an investor to make a larger investment than would otherwise be possible.  The borrowed money can be invested in a number of ways, including direct shares, property and managed investments.

Negative gearing occurs when the interest payable on borrowed funds exceeds the net income received from the investment.  The investor must have surplus income over and above their day-to-day living expenses to meet the shortfall. Gearing can be an effective strategy if the after tax capital gain return of the geared investment exceeds the after tax costs of funding the investment. The leverage effect of gearing is illustrated below:

From the above graph, it can be shown that, with a geared strategy, any capital gains made on the investment are magnified compared to a non-geared strategy. However, the opposite is also true, capital losses are also magnified when using a geared rather than a non-geared strategy. This is the predominant risk associated with gearing.

The risks of gearing

The risks associated with negative gearing make it unsuitable for some investors. It is essential to carefully consider these risks and to seek investment and taxation advice before proceeding with this strategy.  The specific risks associated with negative gearing include: 

Timing mismatch.  It is important not to rely solely on investment income to meet interest payments, as investment income may be irregular and the interest payment may be due before the income is received from the investment.  In particular, negative gearing reduces your cash flow because the investment income does not cover interest costs, which may result in a reduction in both cash flow and the ability to service the interest costs.

Fluctuations in interest rates.  If the income from investments does not change, but interest rates on borrowed funds increase, then you will incur additional costs that will need to be covered from other sources.

Reduction in capital value.  Although there are potential wealth creation benefits to be gained from gearing, these benefits are achieved at the expense of higher risk.  The following table illustrates that although gearing has the potential to increase capital gains in a rising market, it can also compound a capital loss in a falling market.

Suitability of Gearing

Gearing is best suited to people who have a high risk tolerant attitude to investment, a high level of disposable income and are prepared to hold their investments for at least five to seven years.   The potential benefits of negative gearing include: 

Potential for increased capital gains and diversification.  Gearing increases the size of an investor’s portfolio by allowing them to purchase additional investments with borrowed funds.  Capital gains in excess of the after tax cost of funding the geared investment are added to the portfolio’s overall return.  By increasing the number of securities in an investor’s portfolio, the volatility of the overall investment portfolio may be reduced due to greater diversification.

Taxation.  Under current legislation, interest payments on money borrowed to invest in income producing investments, together with ongoing expenses, can normally be claimed against your taxable income.  Investors on high marginal tax rates will receive a higher tax deduction and investors on lower marginal tax rates can potentially make greater use of imputation credits and will incur a lower capital gains tax liability when they sell their investment.

Gearing Options

Lending Facility	Pro’s	Con’s
Geared share fundMay be suitable for Self Managed Super Funds	·          No risk of margin calls·          Investor does not have to borrow (leverage is obtained via institutional borrowings)·          Escalated returns and risk as the investments are internally geared·          The funds are usually actively managed with the objective of neutral gearing.·          Simple paperwork – no need to complete borrowing applications	·          Greater volatility (relative to regular non-geared equity funds) due to the gearing within the fund·          No obvious visible tax deduction to the client, although leverage benefit is received by the client
Home equity loan	·          Limited restrictions on what you can invest in·          Funding available determined by equity in your home·          No margin calls·          Lower cost of finance than margin lending	·          If the investments fall in value, your home could be at risk if you cannot otherwise repay the loan·          Paperwork (and some Government and legal costs) may apply to the loan
Margin lending	·          Security of shares or managed investments required·          Relatively broad range of investment choice	·          If the value of the investment falls, you may be asked to invest more money ·          Some restrictions on what you can invest into
Instalment warrantsMay be suitable for Self Managed Super Funds	·          Leveraged exposure to individual or basket of underlying securities·          Boosted yields via higher levels of dividend and franking credits	·          Generally higher interest and borrowing fees relative to other options·          Must hold instalment warrant at term expiring to own the shares outright·          Administration and time to manage
Structured products/protected equity loanThese comments are general in nature as product features vary significantly	·          Guaranteed not to lose money if the investment falls in value and it is held until maturity·          No margin calls·          Able to borrow up to 100% of the money being invested	·          The interest rate is substantially higher to pay for the guarantee·          Only a portion of the interest expenses may be deductible due to the capital nature of the protection·          Strict restrictions on investment options and rules governing the extend of the protection·          Very high break even point to cover high finance costs, usually in the vicinity of 5% pa after tax capital growth

Click here [MLC - Margin Lending] for a general guide to the pro’s and con’s of margin lending produced by MLC Limited.   MLC is the wealth management division of the Nationial AUstralia Bank (NAB). MLC provides investment, superannuation and insurance solutions and supports the provision of quality financial advice which helps people achieve and protect their lifestyle and financial goals.

For assistance in helping you create your own wealth creation strategy to help you realise your goals and achieve financial freedom contact us today by either telephone 03 9542 3200 or email blog@freedomfinancialplanning.com.au  

WARNING: The information contained on this website is provided in good faith. While the contents are obtained from various sources that are deemed reliable, it is not guaranteed as accurate or complete and should not be relied upon as such. It is recommended that you seek independent, professional advice before implementing any of the suggestions to ensure that it is appropriate to your needs and circumstances. 

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