Gearing is the term used when you borrow to invest.
It is a strategy, which many investors under take but few stop to review and see if gearing is the best option.
So let’s look and see if gearing is for you.
1. The main benefit for gearing to invest is the tax deductions. People on higher tax brackets with high disposal income suit gearing. The higher the tax bracket the better. If your average tax rate is below 30% then the tax benefits of gearing reduces greatly. I would not recommend a gearing strategy for anyone on a tax rate lower than 30% as there are better options to reduce you income tax.
2. You need to be sure that you have a high free cash flow. If you are relying on income from the investments to cover a majority of the cost of gearing then the risk of the investment goes up.
3. House hold income is also important. If you are a two-income family it is important to make sure you can still meet the gearing commitments if you lose one job. Selling your investment under pressure is a sure way to make a loss.
4. Always consider your other debts and loans when looking at a gearing strategy. Repaying the loan is all the banks care about. They don't care what the loan is for. If you fall behind on the investment loan they will come after you for all loans. You could lose your house.
5. Buying capital-intensive investment assets such as property is the most common use of gearing. This type of investment centres on capital growth as opposed to income. They are long-term investments. Other assets such as shares or managed funds can be accessed through regular investments.
6. Gearing is forced savings. People are more inclined to pay something off these days then save for something. It is the American way (now here in Australia). This can be good and bad depending how much homework you do before hand. If you cannot save, perhaps gearing is for you.
7. Total gearing levels should never be more the 80% of the underlying assets. Repayments on loans should never be more than 30% of total household income. You should also base repayments on 10% interest rates. Stick to these rules and you will allow an enough margin of error.
Gearing to invest is a big decision.
It is a long-term activity. So it is important to cover all your bases and commit to the strategy long-term.
It is important to get the right advice before you sign any paperwork.
Who you should get advice from?
Lawyer – understand your rights under the loan documents issued by the banks.
Accountant – understand the tax benefits in dollar terms to you.
Financial Adviser – explore if there is a less risky way to achieve the same result.
Make sure each of the above only advise you on their expertise and do not cross over into areas outside of this.
Last of all; never take advice only from the person selling you the investment. Always get a second opinion.
If you would like more information about gearing, please call us on (07) 4771 4577.