To borrow, or not to borrow; the important bottom lines

Borrowing money to invest is a strategy as old as investing itself.

The purpose of borrowing to invest, often referred to as financial gearing or financial leverage, is to increase the returns an investor would get on their capital invested.

Financial gearing or financial leverage, like the gearing of a car or bicycle, is when something small has the ability to operate something big.

Financial gearing, at its core, is the level of a person or company’s debt compared to equity. So, this means you start with an amount of money to invest in an asset, then you borrow the rest of the money to enable you to create a bigger investment portfolio with growth investment assets (whether equities or property). Therefore, you invest a small amount of money but receive the returns on a bigger portfolio. This strategy increases potential gains if investments perform well, however it may increase losses if the investments provide overall lower returns than the cost of the gearing.

There are three levels of gearing; positive, neutral and negative.

Positive gearing is where the levels of borrowings are such that the income is in excess of the costs of interest on borrowings and owning the investment (costs could include fees such as property management, administration and owners’ corporation). So, for example, the rent from your investment property is higher than the total of all the costs to hold the property.

Neutral gearing is where the income of the asset is equal to the costs of owning and running that investment.

Negative gearing, as the term suggests, is where the income is less than the costs of owning and running that investment. In other words, there is a financial loss created by owning that investment   (before capital growth or other benefits are considered).

Under the Australian taxation regime, if an investor has a negatively geared investment, this usually creates a tax deduction for that tax payer (against other income in the year that loss was incurred).

An investor generally aims to have an overall positive return where the combination of capital growth and after-tax positive or negative income provides them with an appropriate level of return on their capital invested after all relevant taxes.

Using financial gearing as a mechanism to increase returns is a widely used investment strategy for many.

The two bottom lines in benefiting from financial gearing are:

Firstly, make certain you obey ‘The Three Golden Rules of Investment’.

1. Do your financial planning conservatively and correctly
2. Acquire the right investments
3. Give them time

Secondly, know that over your investment life, a crucial aim is to achieve ‘equity build-up’. This can happen in two ways; one, through capital growth, and two, through debt reduction.

Property cycles can sometimes mean that capital growth is slow. Sydney is a prime example of this; up until about six years ago, the city had nearly no growth at all for ten years. People who owned property investments in Sydney during this time would have been pleased if they had directed part of their surplus income into debt reduction, given capital growth was so minimal. At the same time, pre-retirees who held off retiring so they could put a few more years’ income into their debt reduction would equally have been pleased with this strategy.

So, borrowing may be good, depending upon your circumstances, period of investment and risk profile etc., however always keep the above bottom lines in your focus.