Puzzle Finance Blog

Gearing up for a long investment haul

Share prices are on the up and interest rates are at record lows.

Does it make sense to borrow to invest in Australian shares? It seems many people think it does.

While the value of margin loans is still way below its peak before the onset of the global financial crisis, it is trending upwards. 

Many people will opt to salary-sacrifice some of their pay into their super, and super is still the best tax break going for most people.

But governments are not about to stop tinkering with the superannuation rules.

Having some longer-term savings outside of super could be handy in case access to super is tightened.

But borrowing, or ''gearing'', into shares makes sense only if the investment is expected to produce good capital gains.

While gearing magnifies capital gains, it also magnifies capital losses, and investors need to be able to stomach the additional volatility induced by the gearing. For many investors, there is already more than enough volatility in share prices without adding to that by gearing.

Most financial planners caution that a gearing strategy should only be contemplated by those in secure jobs who can invest for at least seven but preferably 10 years.

Often, someone will lose their job at the time the economy and investment markets are not doing so well.

The risk is the investor is forced to sell into a falling market.

Gearing can also save on income tax.

Many people are familiar with ''negative'' gearing, where the interest costs of the loan and other costs of investing are greater than the income from the investment.

The shortfall reduces the investor's income on which income tax is paid.

But the strategy is worthwhile only if the capital gain is likely to be enough to more than make up for past losses. ''Positive'' gearing is more likely now, given record-low interest rates and the fact bank shares can be bought on dividend yields of 7 per cent or 8 per cent, after franking credits.

It is positive gearing because the ongoing costs are less than the dividends. The investment is making money along the way and the investor will be liable for tax on the net income from the investment.

Five-year margin lending rates start at 8 per cent or so, and less if equity in the home is used as security for the loan.

The security for the margin lender is the shares themselves.

There is always a risk of receiving a ''margin call'' from the lender if the sharemarket falls.

If the minimum gearing ratio allowed by the lender is breached, the investor is required to add cash into the loan to reduce the loan balance or sell some shares and use the money to reduce the loan balance.

Gearing should be approached cautiously. But for genuine long-term investors looking to create wealth, borrowing to invest is worth a closer look.

Independent financial advice is recommended.

Posted by John Collett - Fairfax Digital on 8th May, 2013 | Comments | Trackbacks

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