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How do I borrow to invest? | Updated: 9:54:55 PM, Sunday April 08, 2012
By Trish Power How do I borrow to invest?

If you’re considering borrowing money to invest, then you’re probably a reasonably experienced investor who understands the relationship between risk and return.

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If you’re considering borrowing money to invest, then you’re probably a reasonably experienced investor who understands the relationship between risk and return.

If you have ever bought a home, and you have (or had) a mortgage, then you already understand the mechanics of buying an asset by using borrowed money. A mortgage involves the bank securing an interest against your property, in return for giving you cash to purchase that home, or potentially giving you cash for another home.

If you borrow money, then you must commit to making regular repayments into the future until you repay the loan in full. Even if the investment performs badly, and drops in value, you are still legally required to repay your loan commitments.
 

Gearing means borrowing

Gearing is the term that is often used to describe investing in assets using borrowed money. The two most common forms of gearing are margin lending and negative gearing.

1. Margin lending

Margin lending is when you invest in shares using a loan secured against the shares you purchase. Many Australian financial organisations and stockbroking houses offer margin lending facilities.

Margin lending, in the form of a margin loan, can be used for any type of investment product recognised as suitable security for a margin loan by the bank or financial organisation providing the cash. Typically, a margin lending product enables you to borrow money to invest in a parcel of shares, or in fixed interest securities or even to invest in units in managed funds.

A margin loan works in the following way:

  1. You buy assets with borrowed money and those assets are used as security for the loan.
  2. In most cases, your borrowing limit will be no more than 70% of the market value of the shareholding that was purchased with the borrowed money. The remaining 30% of the market value of the shares is to insulate the bank or broker lending the money from any dramatic drop in the share price.
  3. If the company you’re planning to invest in is considered a high-risk company, or in a high risk sector, then your lender may only lend you 50 per cent of the value of the shares in that company.
  4. If the value of the shares that are subject to a margin loan fall below the amount that you borrowed, then you will be asked to pay cash immediately to your lender to cover the gap in value. This payment request is called a margin call.
  5. A margin call can be quite devastating if you don’t have the cash and you’re forced to sell some, or all, of the shares in a falling market. The lender may accept other shares as further security for the margin loan.
  6. When a share price drops dramatically, as many shares did during the 2008 and 2009 Global Financial Crisis, you will notice a cascading effect with share prices, as share prices fall further due to the forced sale of shareholdings to meet margin calls.

Note: You can also invest in shares using borrowed money by borrowing against your home or accessing the equity in an investment property. By taking out a mortgage against your home or investment property, the shares that you choose to purchase will not be subject to margin calls although your home will be at risk if you’re unable to repay your loan. By accessing equity in a property, you can usually negotiate a lower rate of interest on your loan compared to the much higher rates charged on margin loans.

2. Negative and positive gearing

Negative gearing is the term normally used when you invest in property using a loan secured against the property, or secured against another property, and your expenses in running the investment property exceed the income (rent) that you receive from your tenants. The investment loss on the property can then reduce your taxable income.

When you purchase an investment property, you can claim most expenses incurred while you’re renting out the property, including interest payments on the property’s mortgage. If the costs of running the property are more than the income you earn from rent, then you declare a loss on your property investment in your tax return which in turn reduces the tax you end up paying on your non-property income.

Note: You can borrow to invest in property without incurring a loss on the investment. What this means is that the rent received from tenants covers all of the expenses incurred in running the property, including the interest repayments. If the running costs equally match the rent received, then such a property is considered to be neutrally geared. If the rental income exceeds the property’s running costs, then the property is considered to be positively geared.

3. Other forms of gearing

You can also invest in special geared products offered by financial organisations, although such products are generally only suitable for experienced investors. Examples of such products include instalment warrants and contracts for difference (CFDs).

If you run a DIY super fund (self-managed super fund), then you may be able to borrow to invest within your super fund using a ‘limited recourse’ borrowing arrangement. You can find more information on DIY super and gearing by visiting www.SuperGuide.com.au, a free and independent information website for consumers on superannuation.

Advantages and disadvantages of gearing

The main advantages when borrowing to invest are that you can:

• have a larger and potentially more valuable investment portfolio because you have more money to invest. By using borrowed money alongside your savings, you can increase your investment returns substantially if the value of the asset rises, and if more than one asset, if the value of the bundle of assets rises.
• access the income (if any) generated from the geared investment, which can be put towards the loan repayments.
• claim a tax deduction for the costs associated with taking out a loan, such as the interest charged on the loan, and any monthly loan account expenses.

The main disadvantages when borrowing to invest are that you can:

• increase your losses if the value of your investment falls. Choosing a gearing strategy is riskier when the market is falling, while conversely, a gearing strategy can be highly lucrative when a market is rising.
• Find yourself in the situation where you have to fork out extra cash at unexpected times to cover a margin call (refer earlier). If the amount you owe is greater than the allowed loan ratio, or worse, greater than the market value of the shares then you can expect a margin call.
 

Related links:

This article first appeared on www.LearnerInvestor.com.au, a free information website for investors and beginner investors. This article is written by Trish Power, co-founder of consumer information website, www.LearnerInvestor.com.au, and co-author of You Don’t Have to be Rich to Become Wealthy (Wrightbooks), and author of Superannuation For Dummies (Wiley) and DIY Super For Dummies (Wiley).

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