Borrowing money to increase the amount you have to invest with is called gearing or leveraging. It also provides an opportunity to increase diversification.
While it can increase, or magnify your returns when markets are rising, losses can be bigger when markets fall if you’re forced to sell an investment at a bad time.
The most effective investments for gearing are those which offer the greatest potential for growth shares and property (direct or managed).
By ‘direct’ we mean you manage and own it in your name, and can sell it whenever you want (regardless of whether someone wants to buy it). Common ones include an investment property or bank account.
Because growth assets need to be held for more than 7 years, gearing isn’t appropriate for short term goals like saving for a car you want in 6 months. Gearing is generally a medium to long term strategy (at least 5 to 10 years).
The tax benefits available are most useful if you’re on a higher personal tax rate (37% or higher) and suits those with a greater tolerance of risk (a risk profile of Assertive-Growth or Aggressive-High Growth if you’re borrowing a lot to invest).
However, borrowing to invest only makes sense if the investment return (after tax) is greater than all the costs of the loan, such as interest and fees. If not, you’re taking on a lot of risk for an overall low or negative return.
Types of gearing
There are 3 possible outcomes when investing in things like shares and property: you make, break even or lose money.
Making money = positive gearing
This is where your income from the investment is more than the interest and other expenses. This means you will have extra money in your budget but you’ll have to pay tax on the additional income (what’s left over after all the expenses are taken out).
Losing money = negative gearing
This is where the costs of owning the investment are more than the income it produces and you may be able to claim a tax deduction for certain expenses.
You can usually claim deductions for costs related to dividend income, such as management fees and interest on money you borrowed to buy the shares. The tax office provides guidance.
Expenses relating to investment properties are tricky so get advice from tax specialist. The tax office provide information about rental property expenses.
Breaking even = neutral gearing
Neutral gearing means the income received from your property is equal to the cost of borrowing. This means your tax bill shouldn’t increase or decrease by having the property.
Positive versus negative gearing
Many investors focus on the tax benefits of negative gearing without thinking about the loss they are making - crunch the numbers before you commit.
Gearing super
Gearing super must be done under very strict conditions and options are limited. If you’re comfortable with the risks associated with gearing you can simply choose a geared investment option, if available, through your super fund.
If you have a SMSF, the options are more complex. You could set up a limited recourse borrowing arrangement (LRBA) using your SMSF with specialist help. This means only the lender can get their hands on the asset, usually a residential or commercial property, if you fail to repay the loan.
Find out more at ASIC MoneySmart.