Gearing is where you borrow money to invest. As already mentioned, it is best to pay off all your debts before considering the investment. However, situations will arise where the investment is good and a small amount needs to be borrowed for the deal to work. The loan can be property or shares.
Gearing allows you to increase your investment and potentially earn a higher return. On the downside though, if the investment isn’t worth it, you stand to lose a lot more. Negative leverage occurs when the interest you pay on your loan is greater than the income from your investment (for example, from a rental property). You can claim the loss or difference against your taxes and write it off as a deduction against other income.
Negative leverage is not necessarily the best investment strategy. Even though you get a tax break, it’s still costing you money. That is, you may be saving 25 cents on the dollar, but you have to spend a dollar to achieve it.
People look at negative leverage because they figure they will be able to sell the investment for more than they bought it for, and in the meantime their losses are deductible from other income they earn. They conclude that the Internal Revenue Commissioner is actually helping them finance the growth in value of their property.
If it can be avoided, don’t borrow against your home as an investment. This applies particularly when the investment is speculative. Things go wrong and you wouldn’t want to find yourself (and your family) on the streets without a roof over your head.
If you borrow money to invest, this is known as a margin loan. The additional funds raised allow you to invest more, increasing potential returns, compared to what you would get from your standard savings. It allows you to use other people’s money so that you can get a significant increase in your wealth from a small deposit.
The downside is when stock prices fall below a level and a margin call is made. When this happens, you will have 24 hours to respond in one of three ways. You have to put up the cash, you have to sell assets, or you have to provide additional assets to complete the capital.
If you have a margin loan, make sure you fully understand the terms of your loan, and also have survival strategies in place in case things don’t work out.
