Gearing up for a long investment haul
Does it make sense to borrow to invest in Australian shares? It seems many people think it does.
While the value of margin loans is still way below its peak before the onset of the global financial crisis, it is trending upwards.
Many people will opt to salary-sacrifice some of their pay into their super, and super is still the best tax break going for most people.
But governments are not about to stop tinkering with the superannuation rules.
Having some longer-term savings outside of super could be handy in case access to super is tightened.
But borrowing, or "gearing", into shares makes sense only if the investment is expected to produce good capital gains.
While gearing magnifies capital gains, it also magnifies capital losses, and investors need to be able to stomach the additional volatility induced by the gearing. For many investors, there is already more than enough volatility in share prices without adding to that by gearing.
Most financial planners caution that a gearing strategy should only be contemplated by those in secure jobs who can invest for at least seven but preferably 10 years.
Often, someone will lose their job at the time the economy and investment markets are not doing so well.
The risk is the investor is forced to sell into a falling market.
Gearing can also save on income tax.
Many people are familiar with "negative" gearing, where the interest costs of the loan and other costs of investing are greater than the income from the investment.
The shortfall reduces the investor's income on which income tax is paid.
But the strategy is worthwhile only if the capital gain is likely to be enough to more than make up for past losses. "Positive" gearing is more likely now, given record-low interest rates and the fact bank shares can be bought on dividend yields of 7 per cent or 8 per cent, after franking credits.
It is positive gearing because the ongoing costs are less than the dividends. The investment is making money along the way and the investor will be liable for tax on the net income from the investment.
Five-year margin lending rates start at 8 per cent or so, and less if equity in the home is used as security for the loan.
The security for the margin lender is the shares themselves.
There is always a risk of receiving a "margin call" from the lender if the sharemarket falls.
If the minimum gearing ratio allowed by the lender is breached, the investor is required to add cash into the loan to reduce the loan balance or sell some shares and use the money to reduce the loan balance.
Gearing should be approached cautiously. But for genuine long-term investors looking to create wealth, borrowing to invest is worth a closer look.
Independent financial advice is recommended.
Frequently Asked Questions about this Article…
Gearing means borrowing money—usually via a margin loan—to buy shares. The shares you buy are typically the security for the loan. Gearing magnifies capital gains if the market rises, but it also magnifies capital losses if the market falls.
Borrowing to invest makes sense only when the investment is expected to produce strong capital gains over the long term. Financial planners usually recommend gearing only for investors who can tolerate extra volatility and who plan to hold investments for at least seven, and preferably 10, years.
Key risks include increased volatility (losses are amplified), the possibility of receiving a margin call if the market falls, and being forced to add cash or sell shares into a falling market. Job loss or a downturn in the economy can make these risks worse if you need to raise cash.
A margin call happens when the value of your shares falls below the lender's minimum gearing ratio. If that happens you must either add cash to the loan, reduce the loan balance, or sell shares to meet the lender's requirements—actions that can lock in losses if the market is falling.
Negative gearing occurs when interest and investment costs exceed investment income; the shortfall can reduce your taxable income. Positive gearing is when investment income (for example, high dividend yields) exceeds ongoing costs. With record-low interest rates and bank shares offering attractive dividend yields after franking credits, positive gearing is more achievable and means the investment is generating net income that is taxable.
Five-year margin lending rates typically start around 8% or so. Rates can be lower if additional security—such as home equity—is used to back the loan, rather than relying solely on the shares themselves as collateral.
Many people salary-sacrifice into super because of the tax benefits, but governments may change super rules. The article suggests having some longer-term savings outside super could be handy in case access to super is tightened in the future.
Gearing should be approached cautiously. It’s generally only recommended for long-term, financially secure investors who can tolerate added volatility. Independent financial advice is recommended to assess your personal situation before borrowing to invest.
Call 1300 880 160
Start a chat
Schedule a call
