It can be risky borrowing money to invest, so do your homework or speak to one of our financial planners before you take the plunge.
Borrowing money to invest, otherwise known as gearing or leverage, is a medium to long term strategy (at least 5-10 years) which can build wealth faster. But it’s a strategy you should consider carefully and ensure you know what you’re doing and that you choose the right investment.
There are many ways you can borrow to invest however there are two main strategies. The first and most popular is borrowing against the equity in your home. The second is a margin loan where your share portfolio is used as security for the loan. With a margin loan, the lender requires you to keep the loan to value ratio (LVR) below an agreed level (usually 70%)1, so if your investment value drops or your loan gets bigger, the LVR goes up. If your LVR goes above the agreed level, you'll get a margin call and generally have 24 hours to lower the LVR to the agreed level by either depositing money to reduce the loan balance, adding more shares (or managed funds) to increase the portfolio value or selling part of your portfolio and paying off part of the loan.
Generally, people borrow to invest do so to invest in an investment property or shares, but this wealth creation strategy is complex and it’s not for everyone. Before you take the plunge, we recommend you meet with a financial planner to make sure you’re comfortable with the investment strategy and the risks involved. Saying that, it doesn’t hurt to understand the process involved so you can maximise a successful outcome. Below is some food for thought.
A good way to explain gearing is to consider cash flow. Positive gearing is where your borrowing costs are fully covered by the investment income. Negative gearing is where your borrowing costs (interest and fees) exceed the income you receive on your investment. Both forms of gearing can potentially give you tax benefits, but positive gearing is more likely to give you the added bonus of extra income.
When incorporated into your wealth management plan, borrowing to invest could provide the following benefits:
The benefits of borrowing to invest only work if the after-tax interest rate on your loan is lower than the after-tax rate of return on the investment. For example, if you borrow and invest $100,000, after a while you may have a $10,000 net increase in value (after interest expense and taxes). So now you have a $10,000 profit which you wouldn’t have had if you didn’t take out the loan.
Although borrowing to invest gives you the potential to make more money, it can also magnify potential losses. Here’s the risks you need to consider:
Although tax minimisation shouldn’t be the primary focus of this investment strategy, borrowing to invest may have some tax benefits. These could include:
Borrowing to invest is a high-risk strategy and it’s not for everyone. Before you consider this option, it’s important to understand where your money is, what you can afford to invest and what type of investment makes sense for your personal circumstances.
You should also think about the type of investor you are. If you’re unable to accept risk and would lose sleep if the stock market fluctuated, or you’d sell your investment if there was a stock market dip, then this probably isn’t the strategy for you. It’s important to be confident that your investment has long-term quality and will recover from stock market highs and lows.
If you do decide borrowing to invest is the right strategy for you, following are five tips to consider:
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