At some stage, most businesses and many individuals borrow to make a purchase or to invest. Borrowing to invest is known as gearing, and this includes any type of borrowing to invest, whether it be cash loans for purchasing shares, or a large loan for an investment property or a new business. While gearing is often considered to be highly risky, there is good debt as well as bad debt and the association of high risk with gearing only applies if the borrower has failed to plan for their gearing. Here we look at some of the major pros and cons associated with borrowing to invest.
Liquidity and More Funds
Borrowing allows investors to almost instantaneously access more funds, allowing them to reap larger returns on investments. Having more funds available allows investors to take advantage of opportunities as they arise and diversify their investment portfolio. When a good speculative or share opportunity arises, investors who need quick access to funds will benefit from taking out a quick cash loan. Savvy investors with experience in investing can use quick loans to pool funds and multiply returns, but will lose more (potentially everything) if the market falls and still have to pay off the loan.
One of the most common ways of gearing is by leveraging your house to borrow. Most people already have a mortgage, and if you have built up some equity, you may use this to secure a loan to invest in other assets such as shares, or even another property. There are also risks associated with using equity in your home to invest.
Negative Gearing and Tax Deductibility
Negative gearing is when the interest and costs associated with the investment are more than the income you receive from the shares, property, or any other kind of investment. This loss is offset against any other sources of income that you have so you end up paying less tax.
So negative gearing applies to any sort of money borrowed to purchase any income generating investment, and not only property. For some investments you may also be able to deduct interest as expenses, which would further reduce your tax liability. A common example is a margin loan, where shares are used as security for a loan which is used to purchase more shares.
The overall benefit of reduced tax liability is only one factor in choosing whether or not to borrow to invest. Investors also need to weigh the cost of servicing loans against the returns on investment.
High Interest vs Returns
Depending on the type of loan, gearing may not provide any sort of short-term income. In fact, investors may be facing high interest rates which cancel out the returns, for example with larger fast loans with very high interest rates. Over the longer term however, if the market grows at a higher rate, then borrowers who can hold on to the investments will face significant returns.
For example, gearing in Australia for property and shares has been very popular because both types of assets have provided average returns of over 10 per cent per year over the longer term. Investors must consider their timing, the market cycle, and understand that gearing has the potential to provide multiplied returns as well as losses if the market declines. In addition, if interest rates rise, those with variable loans will find themselves liable for bigger monthly payments.
While gearing may not be for everyone, it may suit aggressive investors who are able to meet the loan obligations consistently over a period of time. Remember that you can always start with a small loan and invest conservatively to gain some investing experience.