Borrowing to invest is also known as ‘gearing’ and can be risky. Gearing can increase your returns when markets rise, but losses can be devastating when markets fall.
Let’s understand the pros and cons of borrowing to invest in to help you decide if it is right for you.
Benefits of Borrowing to Invest
The main advantages of borrowing to invest are:
- it gives you more money to invest
- if you are on a high marginal tax rate, there may be tax benefits, as interest payments on the loan could be allowed as deductions, e.g., interest in a loan to buy a house property, etc.
However, borrowing to invest only makes sense if the investment return (after tax) is more significant than all the loan costs, such as interest and fees. If not, you are taking on much 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 significant 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 dividends, or a tenant may default. Do you have funds set aside to cover this?
Interest Rate Risk
Interest rates on loans could rise. If they rose by 2% or 4%, could you still meet loan repayments?
What if your income stops due to sickness, injury, or redundancy? Do you have a plan to manage this?
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 suit you.
Some lenders let you borrow money using your home as security. It is hazardous to borrow against your home and invest this money. If the investment turns terrible 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 strategy for experienced investors only. If you are looking to use this strategy, ask yourself these questions:
- Do you have secured 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 circumstances, such as having children or a drop in income?
- Will you lose sleep at night if your investment performs poorly?
It is vital to get independent financial advice when you are investing. If a financial adviser is connected to a company they recommend you invest in, this investment may not be best for you.
Margin Loans and Investment Property Loans
Many people borrow to invest in shares through a margin loan or property through an investment property loan. Each carries its benefits and risks. Find out more about margin loans and investing in property.
Negative or Positive Gearing
If you consider borrowing to invest, you need to understand if the investment will be negatively or positively geared.
Negative gearing is when your income from an investment (such as dividends or rental income) is less than your interest and other expenses. If you negatively gear, i.e., your investment would initially make a loss which you hope 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 revenue from your investment isn’t covering your expenses. You will still need to cover the negative cash flow from other sources.
Positive gearing is when your investment income is higher than your interest and other expenses. This means you will have the extra money in your budget, but you will have to pay tax on the additional net income.
Diversify Investments to Reduce Risk
If you are borrowing to invest, you must ensure your investments are diversified. Diversification will reduce your investment risk and expose you less to a single economic event. If one business or sector you’ve invested in fails or performs poorly, you will retain all your money.
The less diversified your investments are, the higher the risk. It is risky to borrow to invest in one company, property, or industry sector.
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. Borrowing to invest is a high risk, and you should seek professional financial advice to ensure this strategy is right for you. 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.