Borrowing to invest

Risky business

Borrowing to invest is also known as 'gearing' and it can be a risky business. Gearing can increase your returns when markets rise, but losses can be devastating when markets fall.

Here we explain the pros and cons of borrowing to invest to help you decide if it is right for you.

Benefits of borrowing to invest

The main benefits of borrowing to invest are:

Smart tip

Borrowing to invest is high risk and you should seek professional financial advice to make sure this strategy is right for you.

  • it gives you more money to invest
  • if you are on a high marginal tax rate there may be tax benefits as you are usually allowed a tax deduction for interest payments on the loan.

However, borrowing to invest only makes sense if the investment return (after tax) is greater than all the costs of the loan, such as interest and fees. If not, you are taking on a lot of risk for an overall low or negative return.

Risks of borrowing to invest

Borrowing to invest is not for the faint hearted. The more you borrow the greater the risk, as you have to repay the loan regardless of the performance of the investment.

Here are some of the major risks of borrowing to invest:

  • Investment income risk - The income you receive from the investment may be lower than expected. For example, a company may not pay a dividend or a tenant may default. Do you have funds set aside to cover this?
  • Interest rate risk - Interest rates on the loan could rise. If they rose by 2% or 4%, could you still meet loan repayments?
  • Income risk - What if your income stops due to sickness, injury or redundancy? Do you have a plan to manage this?
  • Capital risk - The value of your investment may fall and the proceeds from the sale may not cover the remaining loan balance. Do you have other funds set aside for this?

You need to understand and have a plan to deal with each risk. If you are not entirely comfortable with these risks, borrowing to invest may not be right for you.

See how a rise in interest rates can impact your loan repayments.

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Warning

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Some lenders let you borrow money using your home as security. It is very risky to borrow against your home and put this money into an investment. If the investment turns bad and you can't keep up with your loan repayments you could lose your home.

Is borrowing to invest right for you?

Borrowing to invest is a high-risk investment strategy for experienced investors only. If you are looking to use this strategy, ask yourself these questions:

Smart tip

Shop around for a loan that meets your needs. Look at the interest rate, fees and other features, like a redraw facility or the ability to repay the loan early.

  • Do you have secure income from other sources such as your salary to top up the loan if you get a margin call?
  • Do you have a high marginal tax rate to make the most of any tax benefits?
  • Are you in it for the long haul? Gearing is generally a medium- to long-term strategy (at least 5 to 10 years).
  • Is your strategy flexible enough to allow for changes in your personal circumstances, such as having children or a drop in income?
  • Will you lose sleep at night if your investment performs poorly?

It is important to get independent financial advice when you are investing. If an adviser is connected to a company they recommend you invest in, this investment may not be best for you. You can look at your adviser's financial services guide to see any relationships or associations they have with other companies.

Margin loans and investment property loans

Many people borrow to invest in shares through a margin loan or in property through an investment property loan. Each carries their own benefits and risks. Find out more about margin loans and investing in property.

Negative or positive gearing

If you are thinking about borrowing to invest you need to understand if the investment will be negatively or positively geared.

Negative gearing

Negative gearing is when your income from an investment (such as dividends or rental income) is less than your interest and/or other expenses. If you negatively gear, your investment is initially making a loss which you hope you will make up with a capital gain when you sell your investment.

A loss can be used to reduce your taxable income, which will reduce the amount of tax you pay. Remember, you are only reducing your tax because the income from your investment isn't covering your expenses. You will still need to cover the negative cash flow from other sources.

Positive gearing

Positive gearing is where your income from an investment is higher than your interest and/or other expenses. This means you will have extra money in your budget; but, you will have to pay tax on the additional net income.

Case study: Bruce's geared investment

Young man with phoneBruce has a geared investment that this year has cost $10,000 in interest and returned $7,000 in income from dividends. He is negatively geared as his investment is producing a loss of $3,000 per year. He can deduct this $3,000 from his taxable income. If Bruce pays tax on his salary at 39%, he can reduce his tax bill by $1,170 (39% of $3,000).

Although this may reduce his tax, it still costs Bruce money. For the investment to work for him, this loss, and any losses in future years, will need to be offset by a capital gain (after tax) when Bruce sells it, in order for him to achieve an overall positive return.

If the investment decreases in value, Bruce will have lost some of his capital as well as having paid expenses along the way, giving him a negative return on his investment.

Diversify investments to reduce risk

If you are borrowing to invest, it's important to make sure your investments are diversified. Diversification will reduce your investment risk and leave you less exposed to a single economic event, so if one business or sector you've invested in fails or performs poorly, you won't lose all your money.

The less diversified your investments are, the higher the risk. It is risky to borrow to invest in one company, one property or one industry sector.

Find out more about diversification.

Borrowing to invest is not for everybody. Consider if you have the timeframe and discipline, and make sure you understand all the risks before you make a decision.


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Last updated: 08 Jun 2018