The risks and benefits of gearing

Wealth accumulation – accelerated wealth creation by investing a larger amount than an investor could have otherwise invested using their own money.

Potentially pay less income tax – interest and other costs of gearing may be tax deductible, and could potentially reduce taxable income. Such costs are generally tax deductible if the borrowed money is used to invest in an income producing investment.

Utilise existing equity – borrowing against an existing portfolio can unlock equity and enable a larger more diversified investment portfolio to be held.

Bring forward tax deductions – it may be possible to bring forward a tax deduction by prepaying interest (for up to 12 months). This has merit where the current year’s income is expected to be higher than that in the following year and the expectation is that interest rates will rise in the future.

Gearing magnifies gains but it also magnifies losses. If investment returns are less than the gearing costs, the borrower may be unable to service the loan. If so, selling some assets might be required to avoid default.

Loan cost and interest rate risk – changes to interest rates and fees can vary the cost of a loan. Plus, there may be additional charges if a borrower requests terminating a loan.

Capital risk – the investment may not perform as expected resulting in a capital loss if forced to sell.

Income risk – as with any loan, the investor/borrower needs to be sure they can afford to service it. If relying on investment income to service the loan, this source may not always be sufficient. Even if the investor/borrower is relying on regular income from a job or a business, it’s important to make sure their cash flow is sufficient to meet both the loan repayments and living expenses – and to build up some reserve capital for unexpected events. Consideration should also be given to what would happen if their income is affected by illness or accident – and the value of having insurance cover for this.

Legislative risk – changes in tax legislation and the regulatory framework may reduce the tax benefits of gearing.

Borrow less than can be afforded – to help ensure regular interest payments can be easily met in case things don’t go according to plan.

Invest in high quality investments – this may reduce the risk of negative returns.

Invest for the long term – this may give time to ride out any downturns in the market and take advantage of the upturns.

Diversify the investments – spread risk over a range of asset classes and / or securities so the poor performance of one asset class has a limited effect on total returns.

Repay loan interest regularly to help prevent the level of gearing increasing (and to avoid a margin call, in respect of a margin loan).

Reinvest the income earned from investments – this will reduce the loan to valuation ratio.

Regularly review the loan position.