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Borrowing to invest: Know the risks first

 

Borrowing to invest: Know the risks first

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.

How do you borrow to invest?

There are two main ways to borrow to invest. The first and most popular is borrowing against the equity in your home. The second is a margin loan where your share portfolio becomes the 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, but 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.

Positive or negative gearing?

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.

What are the benefits of borrowing to invest?

When incorporated into your wealth management plan, borrowing to invest could provide the following benefits:

  • Ability to leverage your existing capital to grow your wealth faster;
  • Potential to invest more money for higher returns;
  • Flexibility to diversify your investment portfolio; and
  • Possible tax 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.

What are the risks?

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:

  • Bigger losses — Borrowing to invest increases the amount you'll lose if your investment decreases in value. And remember, you’ll still need to repay the loan and interest no matter how well the investment performs.
  • Capital risk — The value of your investment may go down, so if you have to sell the investment quickly, it might not cover the loan balance. This means you’ll need to use another monetary source (like an emergency fund if you have one) to pay the balance.
  • Investment income risk — The income from an investment may be lower than you expected (for example, a renter may move out or a company may not pay a dividend), so you’ll need to have funds set aside to cover your living costs and loan repayments.
  • Interest rate risk — If you have a variable rate loan, the interest rate and interest payments could increase which could impact your cashflow.
  • Legislation may change – Keep in mind there may be tax changes for geared assets in the future.
Are there any potential tax benefits?

Although tax minimisation shouldn’t be the primary focus of this investment strategy, borrowing to invest may have some tax benefits. These could include.

  • The running costs of a property, including loan repayments and taxes, may be tax deductible.
  • Depreciation on your property or capital asset may be tax deductible.
  • If the property is negatively geared, your income losses may be used to reduce your assessable income and overall tax.
  • Share investments may attract franking credits which can be used to offset tax payments on other income.
Is borrowing to invest right for me?

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.

Ask yourself these eight questions
  1. Are you comfortable going into debt for an investment that may fluctuate in value?
  2. Can you afford to lose the collateral you put up for the loan? Any asset used as collateral, including your home, can be taken by the creditor to satisfy the loan.
  3. How will you pay for the loan if your investments fall in value? Do you have a secure salary, a cash reserve or other sources of income?
  4. What are the terms for repaying the loan and interest?
  5. Are there any other fees associated with the loan?
  6. Are the investments you’re buying with borrowed money suitable for your goals and risk tolerance?
  7. How much will you have to pay in commissions and fees?
Tips on borrowing to invest

If you do decide borrowing to invest is the right strategy for you, following are five tips to consider:

  1. Shop around for the best loan - by shopping around, you could save a lot in interest and fees or you could even find a loan with better features.
  2. Don’t maximise your loan amount – don’t borrow the maximum amount the lender offers you. Remember, the more you borrow, the bigger your interest repayments and potential losses.
  3. Pay the interest repayments – this will prevent your loan and interest payments getting bigger each month.
  4. Have a safety net – Make sure you have an emergency fund, so you don't have to sell your investment if you need cash quickly.
  5. Diversify your investments - Diversification may protect you if a company or investment falls in value.

We’re here to help

If you’d like more information about the best strategies for investing to suit your needs, an EISS Super financial planner can help. To make an appointment call 1300 369 901 (select option 2), Monday to Friday, 8am to 8pm AEST.


1 Source: Moneysmart, How to invest, Borrowing to invest.