Gearing means borrowing money so you can invest in a greater range of assets and earn potentially higher returns.
But like all types of investment, gearing is not without risk. While investing more money gives you the opportunity to increase capital gains, it can also lead to increased losses if the investments don't perform well.
It's important to have a clear understanding of the potential benefits and drawbacks before deciding if gearing is right for you.
Gearing involves borrowing money to invest in assets to generate a higher return than the cost of borrowing over the long term.
For example, an investor borrows $100,000 at an interest rate of 5% pa. They invest in shares that generate a return of 10% pa in income and capital growth. This means they can earn a return of 5% pa after deducting the interest costs.
There are two main types of gearing: positive and negative.
When the income that is generated by the investment is greater than the cost of borrowing, it's positively geared - resulting in positive cash flow.
When it's negatively geared, the cost of owning the investment is more than the income the investment generates. In other words, the investment is not generating enough income to cover the cost of borrowing. This can result in a loss, but the loss can be claimed as a tax deduction against other income which can help to reduce your overall tax bill.
Some benefits of gearing include:
If you are considering gearing, there are some downsides to be aware of:
Here's an example of how gearing can work when investing in property.
Bill has $300,000 in savings and decides to purchase an investment property worth $1 million.
He uses $300,000 of his own funds and borrows the remaining $700,000 through a loan with an interest rate of 5%. Bill makes interest payments of $35,000 per year on the loan.
Assuming the rental income from the property covers the loan interest payments and other expenses—management fees, rates, and insurance—if the property's value appreciates by 5% to $1.05 million over the course of a year, Bill's net worth would increase by $50,000.
If the property value decreased by 5%, Bill's net worth would decrease by $50,000, leaving him with $250,000 in equity (his original $300,000 deposit minus $50,000) and owing $700,000 in loans.
Determining if you should take on a gearing strategy depends on a variety of factors, such as your investment goals, risk tolerance, financial situation, and investment timeframe.
It's important to consider things like:
As always, seek professional advice before making any investment decisions.
Gearing can be a useful tool for investors looking to diversify their portfolio and potentially increase their returns. It is important to approach gearing with caution and have a clear strategy in place to manage any risks.
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Taxation law is complex, and this information has been prepared as a guide only and does not represent taxation advice. Please see your tax adviser for independent taxation advice.
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