An article by ASIC Chairman Jeffrey Lucy, published in The Daily Telegraph, February 2007.
Note: The views expressed are those of the author. For more information about this topic, read Moneysmart's resources on borrowing to invest.
Borrowing money to invest, or 'gearing', can be a high-risk venture and great care needs to be exercised, especially if you're investing for the first time or you are borrowing large amounts of money.
Negative gearing is where your borrowing costs (interest and fees) exceed the income you receive on your investment, and positive gearing is where your borrowing costs are fully covered by the investment income.
While gearing can increase the potential profit on your investment (because you have more money to invest), this also means it can increase your losses if the increase in the value of the investment does not exceed the gearing losses.
So, should you borrow money to invest?
Many people and businesses borrow to invest every day. Generally, as long as the investment itself is sound, borrowing can be sound too. If you are an experienced investor, are in a high income tax bracket and have income from other sources, then gearing can work for you.
That's not to say, though, that gearing is for everyone. Individuals and businesses should look carefully at their own financial situations before choosing this investment strategy.
I think there are two possible advantages of gearing.
You can increase potential profits
If you borrow money to invest in shares or real estate, and they increase in value, then you get the benefit of that gain on your original investment (capital gain) when you sell the asset (less the borrowing costs). Equally, you get the benefit of any dividends, bonus share issues or rents that may be made while you own the asset.
You can obtain a tax benefit
Negative gearing is when your income from the investment is less than the cost of the investment (that is, interest that you are paying to your lending institution on the loan). The difference between the two amounts can generally be used as a deduction on your taxable income. Needless to say, the benefit of any tax deduction is dependant on tax rates payable by the investor.
A decision to borrow to purchase an asset requires serious consideration. Specifically, gearing is a strategy best suited to you if:
- you have enough income from other sources, like a secure salary, or have a reserve of funds to meet possible margin calls if there is a significant drop in the market;
- you are in the highest income tax bracket, where the tax deductibility of the interest payments is maximised so the actual cost of the borrowed money is reduced as much as possible; and
- you are an experienced investor, having a practical appreciation of the volatility of your investments and the risks involved.
But deciding whether to borrow money to invest depends on your own personal needs and circumstances.
If you are not sure, get advice from a licensed adviser, who is obliged under the law to look at your personal situation. It could be the difference between potentially making a profit or risking your investment with the possibility of further losses if the sale of the asset does not cover the original debt.