Is borrowing to invest a good idea?
When buying a home, most people save a deposit, find a place they think will grow in value, work out if loan repayments and other expenses are affordable, and then borrow the money needed to make the purchase.
This process is widely understood and adopted when it comes to property – but less so with other assets, like shares. However borrowing to invest, also known as gearing, can be a sound strategy to accelerate your earnings and wealth.
Gearing does involve a number of risks, so it’s important to understand these as well as the potential benefits, when deciding if it’s the right strategy for you.
How does it work?
One method of gearing is to take out a margin loan, and use the borrowed funds to buy shares. The lender uses the shares you buy as security for the loan. However, because shares can fluctuate in value very quickly, the lender manages this risk by setting a loan to value ratio (LVR), which you need to maintain.
The LVR is the amount of your loan divided by the total value of your shares, and is typically set at a maximum of 70%. If your shares drop in price and you exceed your maximum LVR, you’ll have to quickly deposit some extra cash and/or sell some shares.
What are the benefits?
You have more money available to invest: You can buy more shares than you could if you were just using your own money, which can help to increase your returns and accelerate your wealth.
It may be tax effective: Usually, the interest payments on the loan are tax deductible to the extent that the loan amount is used to purchase the shares. In these circumstances generally, borrowing to invest may give you some tax advantages.
What are the risks?
You may get a margin call: Your lender may require you to deposit additional funds with very short notice. Lenders can change the maximum LVR at their discretion.
Your losses can be magnified: This can happen if the value of your shares drops below your remaining loan value, as you still have to repay the loan. If your shares drop considerably, you can lose more than your initial investment amount.
Interest rates can change: If interest rates increase, your costs of servicing the loan will increase.
Income risk – if your income ceases due to sickness, injury or redundancy and you can’t service the debt/loan repayments.
What else you need to consider
As a general rule, your after-tax investment return should be higher than the cost of the loan (including fees and interest). If it’s not, you may be taking on more risk than you need to for a low return.
Make sure you have reliable income from other sources in case you receive a margin call, or interest rates change. It’s also important not to invest simply because of the tax deduction alone.
Speak to an expert
While there can be benefits in gearing, it’s essential to understand the potential risks. So it makes sense to speak with your financial adviser and/or registered tax agent before you borrow, to help you decide if it’s the right strategy for you.
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