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Instructions on how to use the calculator Enter the amount of cash you wish to invest and select the time period over which to calculate the estimated growth. The graph below will update to show the estimated growth at various gearing ratios. To obtain the estimation numbers place your mouse over each bar.
** Initial investment of $60000 invested for 5 years with various gearing ratios 'Gearing' simply means borrowing money to invest. In the same way that you can borrow money to buy a family home, you can also borrow money to buy other assets in order to build your wealth
A gearing strategy can magnify your investment returns simply because it means you have more money to invest. Of course, the flip side is that gearing can also increase your losses if your investments fall in value. How can gearing increase your wealth? An example Jill has $60,000 invested in a unit trust (Australian shares) and she wants to increase her returns via a gearing strategy. Working with her adviser, Jill considers three options: Option 1. Maintain her investment at its current level of $60,000 Option 2. Double her investment by borrowing $60,000 (i.e. 50% gearing) or Option 3. Increase her investment even more by borrowing $120,000 (i.e. 67% gearing). Options 2 and 3 are negative gearing strategies, as interest payments will be greater than the income from the investment. Value of investment after 5 years (including repayment of loan)
Assumptions:
The above graph illustrates the benefits of gearing. The 67% gearing strategy (Option 3) has significantly increased Jill's net returns compared with a no-gearing approach (Option 1). What's more, higher gearing levels can provide greater tax benefits. How can gearing help you save tax? Gearing not only increases your potential to make money, it can also save you tax. If you invest the borrowed money in shares or managed funds, you may receive franking credits that can help your tax position.also be able to deduct the difference between the interest you pay on your loan and the income you earn from your investments. This is known as 'negative gearing'. How does negative gearing work? If the interest payments on your investment loan (plus costs) are more than the income you receive from your geared investment, you may be able to use the difference to reduce your assessable income. For example, let's say you borrow $100,000 at an interest rate of 8% p.a. and invest it in an asset that produces an annual income of 6%:
If you're on the top marginal tax rate (currently 47%) this little scenario will save you $940 in tax per annum! What about positive gearing? Positive gearing, on the other hand, occurs when the income you receive from an investment is greater than the interest payments. If that creates a tax problem, well . . . that's a nice problem to have. But you shouldn't lose sight of your long-term goals. Regardless of the short-term impact on your cash-flow or tax position, for a gearing strategy to be successful in the long term, the investments you buy with the borrowed money must eventually increase in value enough to offset any interest payments on your loan (plus costs) and make a profit overall. That is, your capital gains plus income must eventually outweigh your accumulated interest payments and costs. How can you get into gearing? There are a variety of ways you can borrow money to invest. For example, you can borrow against the equity you have in your home, or you can take out a margin loan with a lending institution. In most cases, the lending arrangements are quite flexible, often with no fixed term and the option of paying interest on a regular basis or in a lump sum. You can also use your dividends and income distributions to pay interest, or reinvest the income to buy more units or shares. With a margin loan, your investment assets form the security for the loan. Margin lending institutions will typically lend up to 70% of the value of certain assets. For example, if you have $30,000 you want to invest in a unit trust, you may be able to borrow another $70,000 and increase your investment to $100,000. If you have a good income but you don't have a lump sum to use as security for a margin loan, you could consider instalment gearing What are the risks of gearing? In addition to the usual investment risks Ð e.g. market volatility Ð any gearing strategy carries additional risks. Depending on your circumstances and the terms of your investment loan, these may include:
Since you are borrowing money to invest, there is also the risk that you may have difficulty repaying the loan, whether due to illness, injury or a change in employment status. For this reason, you may consider taking out income protection insurance. What is a margin call? A margin call is a demand from a margin lending institution that you make an immediate loan repayment or invest additional money to cover a fall in the value of your investment. A margin call occurs when the ratio of your loan (i.e. borrowed money) to security (i.e. your total investment) exceeds an agreed amount (called the 'buffer'). When can you expect a margin call?
A. We'll assume you have $30,000 of your own money and you borrow an additional $70,000. Therefore, the LSR is 70%.
B. If your total investment rises in value to to $120, 000 your L.S.R is reduced to 58% C. However, if your total investment drops in value to $80,000, your LSR is increased to 87.5%, which is above the original LSR plus a 10% buffer. The lender will then make a margin call, and you'll have to restore the LSR to the original ratio (point D). When a lender makes a margin call, you must restore the original Loan to Security Ratio (LSR) by either:
Different margin lenders and different margin loans have very different terms and conditions. Some have 5% buffers, others have 10% some require margin calls to be paid within 24 hours and others give you a few days' grace. You should read the terms and conditions of any margin loan agreement very carefully before you invest and seek professional financial planning advice to ensure that you can cover any margin calls that may need to be made. Is gearing right for you?
Successful gearing requires a disciplined, long-term commitment and very high quality assets. You should be comfortable with risk (market volatility) and be able to meet interest payments and any repayments on your loan, as well as any margin calls. How does instalment gearing work? Instalment gearing is basically a hybrid of a regular savings plan and a margin loan. With an instalment gearing plan, you can leverage your regular investments into a share portfolio or unit trust with regular drawdowns on an investment loan. Instalment gearing can be a very powerful savings strategy for investors with a good income but no lump sum to invest. You should talk to a financial adviser about whether instalment gearing is right for you. Importantly, instalment gearing also enables you to 'average' your investments in the market, which can be a more reliable strategy than trying to time your entry into the market. Instalment gearing can leverage your regular savings The graph overleaf compares the returns of three different investors over a five year period. Each investor starts with $1,000 to set up their plan. Investor A uses a no gearing strategy. She has not borrowed any money, but invests $250 per month over the five years. The total amount invested is $16,000. Investor B uses a 50% gearing strategy. She borrows an additional $1,000 to begin with plus $250 per month for five years. She also invests $250 per month of her own money. The total amount invested over five years is $32,000. Investor C uses a 67% gearing strategy. She borrows an additional $2,000 to begin with plus $500 per month to add to $250 per month of her own money. The total amount invested is $48,000.
Assumptions: The above graph shows how gearing can increase your returns. However, for a fairer comparison, we need to repay the money borrowed by Investors B and C. You can see in the chart overleaf that even after repaying the debt, Investor C, using a 67% geared strategy, has accumulated more wealth than Investor A who did not borrow any money. For simplicity, this example has not taken into account the yearly cashflows experienced by each investor.
Gearing into shares or property: Which is best? Most geared investors invest in property and/or shares, as these asset classes are most likely to produce assessable income and capital growth over the long-term. But which is the best asset class for a gearing strategy: property or shares? Compared with direct property, shares (whether direct or through a unit trust) offer some distinct advantages, including:
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