Key takeaways

• Gearing involves borrowing money to invest in assets to generate a higher return than the cost of borrowing over the long-term

• You may be able to claim a tax deduction on the interest payments of your loan to reduce your taxable income

• One drawback is you’ll need to pay interest on the money you borrow which can reduce your overall return.

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.

What is gearing?

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.

Types of gearing

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.

Benefits of gearing for investors

Some benefits of gearing include:

1. Access to higher yielding assets: gearing can provide investors with access to assets they may not be able to afford. For example, commercial property may provide higher rental yields compared to residential property or other investments
2. Diversification: gearing enables you to diversify your portfolio by investing in a range of assets. This can also help to reduce risk by spreading investments across different asset classes and sectors
3. Tax benefits: you may be able to claim a tax deduction on the interest payments of your loan to reduce your taxable income
4. Tax credit on dividends: if you choose to invest your borrowed money into shares, you may receive a tax credit on the dividends you earn (known as 'franked dividends'). This means you could be paying a small amount of tax on this income which can have a positive effect on your cash flow
5. Protection against inflation: gearing enables you to access assets that are likely to appreciate in value over time. For example, a property investment can generate increases in rental income and capital appreciation
6. Long-term investment: gearing can be a suitable strategy for investors with a long-term investment timeframe. The benefits of compounding returns and capital growth can outweigh the costs of borrowing money.

Possible drawbacks of gearing for investors

If you are considering gearing, there are some downsides to be aware of:

1. Interest costs: you’ll need to pay interest on the money you borrow which can reduce your overall return. If the investment performs poorly, the interest costs can also outweigh the returns
2. Access to money: if you’re relying on your investments to generate income, you may find it difficult to access your money in the short-term, particularly if the investment isn’t performing well
3. Complexity: gearing can be a complex investment strategy that requires careful planning and management. It is important to understand the risks involved and to have a clear strategy in place
4. Inability to generate an income: an injury or illness that prevents you from working, or a change in employment circumstances, could make it difficult to cover investment expenses including loan repayments
5. Changes in the environment: a rise in interest rates, or a reduction in dividends or rental income, can significantly impact your investment returns. Make sure you have sufficient income and a cash reserve to comfortably meet loan repayments
6. Margin calls: a margin call can occur if your loan balance exceeds your maximum loan limit. This may happen as a result of a market downturn which causes your portfolio fall in value. As a result, you may need to add additional cash or sell existing assets.

Case study example: gearing to invest in property

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.

Is gearing right for you?

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:

• Will gearing align with your investment goals—for example, if your goal is to generate capital growth in investment, gearing to invest in property may be a suitable option
• How comfortable are you with taking on risk
• Do you have the capacity to take on debt—it's important to ensure that you can afford to make loan repayments and have a buffer in case of unexpected expenses
• How long you are willing to hold the investment.

As always, seek professional advice before making any investment decisions.