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Blog | Borrowing to invest; the benefits and the risk.

With interest rates at all-time lows, investors may wish to consider the merits of a geared investment strategy, or put simply, borrowing to invest. 

A geared investment strategy involves borrowing funds from a lender and investing this borrowed capital into growth assets, such as property or shares. The objective of this strategy is to invest an increased capital amount, via borrowings, that generates positive returns over and above your interest repayments, therefore magnifying your investment gains. However, it’s very important to note that investment losses are also magnified. 

Provided investment returns are positive, a geared investment strategy can have the following benefits: 

  • Allows you to invest sooner rather than saving the capital to invest. 
  • Allows you to use the bank's money to generate wealth.
  • May provide an opportunity to purchase an asset or diversify into other assets that you may not have been able to do with your own capital.
  • May provide tax efficiencies through negative gearing, should the interest expenses exceed the investment income.
  • Greater growth can be achieved by increasing the amount of funds you invest.

With interest rates at record lows, borrowing is as cheap as it has ever been. The investment return required to make the strategy effective is now much lower than it has been in the past. Provided the after-tax return on borrowed funds outweighs the cost of the debt, the strategy would be worthwhile. 

However, the strategy is not without its risks, some of which include: 

  • Investment risk – If the value of the investment falls, losses are amplified. Investors must remember that when the value of the investment falls in value, they still owe the bank what they borrowed. The more you borrow, the greater the risks become.  
  • Cash flow – In circumstances where negative gearing comes into play, the annual borrowing costs could be greater than the income return, which would result in negative cash flow. 
  • Servicing the loan – You still must service the interest on the loan, irrespective of the income the investment generates. For example, if you borrowed funds to purchase an investment property and the property was vacant or untenanted for a period of time, there would be no income yet you would still need to cover the full interest repayments.   
  • Rising interest rates – If interest rates increase in the future, the higher interest costs reduce your net investment return.  
  • A highly geared strategy carries additional risk. If the market moves against you and asset prices fall, the lender may require additional capital. 

Get the Strategy Right 

It's important to set up an appropriate strategy from the beginning. This may involve seeking professional advice. 

How much borrowing you undertake would depend on several factors including your ability to service the debt and your level of assets/equity.  

Consideration of the ongoing strategy is also important. The general concept of a geared investment strategy is to invest in growth assets, such as shares. For example, if you invested a sum of borrowed money into shares and the market suffered a correction, you may want to design a strategy that allows you to purchase additional shares while the market is low, or ‘buy low’. This may require going back to your lender for additional funding. 

The same applies when you invest in assets that appreciate, you may want to have a strategy that involves taking profits. While this can simply be achieved with company shares, it’s not quite that simple with an investment property. 

Lastly, what is the end game from the strategy, at what point in time would you sell assets / repay the debt? This is something that requires careful planning with respect given to your long-term objectives. 

While a geared investment strategy can provide significant benefits, it also carries risks and should only be adopted with careful consideration or professional financial assistance.  It is an investment strategy we regularly deploy with our clients as part of their bespoke strategy development, 

 

Hewison Private Wealth is a Melbourne based independent financial planning firm. Our financial advisers are highly qualified wealth managers and specialise in self managed super funds (SMSF), financial planning, retirement planning advice and investment portfolio management. If you would like to speak to a financial adviser on how you can secure your financial future please contact us 03 8548 4800, email info@hewison.com.au or visit www.hewison.com.au

Please note: The advice provided above is general information only and individuals should seek specialised advice from a qualified financial advisor. The views in this blog are those of the individual and may not represent the general opinion of the firm. Please contact Hewison Private Wealth for more information.