Creating Wealth by Gearing Up

Business - November 4th, 2005
Magellan Japan

Tel. 03-3769-5511

Sometimes borrowing is beneficial

‘Gearing’ is when you borrow money to invest. It is best to clear all your consumer debt before looking at investment. However, situations will arise where the investment is a good one and it is necessary to borrow a small amount to make the deal work. The borrowing may be for property or shares.

Gearing allows you to increase your investment and potentially obtain a higher return. On the downside, if the investment does not produce the projected pay off, you stand to lose a lot more.

If it can be avoided, don’t borrow
against your home for investment

Negative gearing is not necessarily the best investment strategy. Even though you get a tax break, it is still costing you money. That is, you may be saving yourself twenty-five cents in the dollar, but you have to spend one dollar to achieve that.

People look at negative gearing because they calculate that they will be able to sell the investment for more than they bought it and in the meantime their losses are deductible off other income they earn.

If it can be avoided, don’t borrow against your home for investment. This applies particularly when the investment is speculative. Things do go wrong and you wouldn’t want to find yourself (and your family) out on the street without a roof over your head. The exception to this is if you release capital from your home to buy further investment property. You could always move into one of the properties if anything went amiss.

If you borrow money to invest in stocks, bonds, or mutual funds, this is known as margin lending. The extra funds raised allow you to invest more, increasing the potential returns, compared to what you would get from your standard savings. It allows you to use other people’s money so you can get a significant increase in your wealth from a small deposit.

The negative side is when share prices fall below a level and a margin call is  made. When this happens you have to respond in one of three ways. You have to come up with the cash, you have to sell assets, or you have to provide additional assets to top up the equity.

Used prudently, gearing is a useful tool for building wealth over the medium to long term. Short-term borrowing for short-term gain can appear attractive but if the quality of the investment you are looking to go into is speculative, the volatility could not only produce spectacular gains but equally spectacular losses.

If you have a margin loan, make sure you fully understand the terms of your loan and also put in place survival strategies in case things don’t work out.