In simple terms, gearing is borrowing money to invest. The investment could be in direct shares or managed investments, such as an equity trust, balanced fund or property. Gearing is, in essence, directed towards producing a larger investment return by using borrowed funds, often in addition to your own funds, so that financial goals can be achieved more quickly. Gearing can be used as part of the overall investment strategy to help build your wealth. It gives you greater potential to generate wealth because you have more money in the investment market.
Gearing can be used to accelerate your investment returns
Borrowing allows you to invest more money than if you invested only your own funds. Although gearing has the potential to increase capital gains in a rising market, it can also increase capital losses in a falling market. Any gearing strategy should be approached with caution.
Gearing can help you keep all the profits
After you cover the borrowing costs and tax, 100 per cent of the growth and the income you earn on the investment are yours to keep.
When you borrow to invest in income-producing investments, the interest on your loan is treated as an expense for tax purposes. This generally means that you can claim the interest as a tax deduction.
Gearing is best suited to people who are comfortable taking extra risk with their investments and those who can cope with potentially large fluctuations, both up and down, in the value of their investments.
Gearing is most appropriate if you:
Gearing aims to increase the investor’s return by using borrowed funds in addition to their own capital. It is an effective strategy if the after-tax capital gain and income return of the geared investment exceeds the after-tax costs of funding the investment.
It is best to gear against growth-based investments, such as shares and property, and gearing should always be viewed as a long-term strategy. You need to be able to retain the investment and maintain loan repayments for at least five to ten years to obtain the benefits of long-term growth.
The fundamental rule is that gearing an investment only makes sense if: