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Gearing and Margin Loans

Gearing is simply borrowing money to invest. By adding borrowed funds to your own funds, you increase the total amount invested. So the returns, as a proportion of your original capital, are ‘geared up’, or magnified.

Australians have generally geared into property via their home or an investment property. But increasingly, more people are realising the benefits of gearing into the sharemarket. Not only is there an increased opportunity to create wealth, gearing also offers greater portfolio diversification and potential tax efficiencies.

Successful people have long recognised that by borrowing money and investing it wisely, they can grow their wealth faster than if they had used only their own funds. But just as importantly, are understanding the risks of gearing and how they can be managed.

Degrees Of Gearing: Negative, Neutral And Positive

There is a common misconception that gearing automatically means negative gearing. In fact, an investment can also be neutrally or positively geared.

It all depends on how much you borrow, how much interest you pay, how much income you receive from the investment and the tax efficiencies involved.

The degree of gearing you choose will depend on your objectives and your own financial circumstances. The more highly geared you are, the greater the potential rewards and the greater the potential risks.

What Is A Margin Loan?

A margin loan is simply a line of credit to buy shares or units in managed funds, where your portfolio is the only security required for the loan. It can be a powerful tool to access new investment opportunities, or to multiply possible returns from your current investments.
Why Use A Margin Loan?

By using a margin loan you have more funds to invest, which could magnify your potential returns. You’ll also have the ability to increase the range of securities in your portfolio, which can help reduce your investment risk.

You may also be entitled to claim loan interest as a tax deduction where the loan funds are used for business or investment purposes – a deduction that can be applied against your investment earnings and other taxable income earned during the year.

What Are The Risks Of A Margin Loan?

The main difference between a margin loan and, say, a conventional property loan, is that shares and managed funds change in value each day. This means the lender will monitor your portfolio value, and if it falls below an agreed minimum, you will be issued with a margin call.

If this happens, you must provide additional funds to restore at least the minimum equity position.

What Is A Margin Call?

If your equity – the value of the assets that you contributed to the investment – falls below the agreed lending ratio, you may be issued with a margin call. If this happens, your lender will ask you to provide additional funds to restore at least the minimum equity position.

To help protect against small market fluctuations, there is usually a ‘buffer’ (typically 5% of your total portfolio value) within which a margin call may not be made.

Understanding The Risks

Gearing can magnify your investment returns, but it can also increase your risk of financial loss, which is why it makes sense to understand the different types of risk involved, and how to manage them.

The risks of gearing include:

    • Margin calls;
    • Added exposure can increase losses;
    • Sharemarket risks;
    • Interest rate risks;
    • Changes to taxation legislation.

Gearing does have its risks, but there are ways in which you can manage your investment to maximise the benefits while minimising the potential downsides:

Gear Conservatively
Don’t overextend your borrowings. Consider your ability to meet interest payments and possible interest rate changes.

Diversify Your Investment Portfolio
Never rely exclusively on one investment, or one type of investment. Aim for a balance across sectors – don’t put all your eggs in one basket.
Invest For The Long Term
To ride out the unpredictable characteristics of the sharemarket, invest for a minimum of five years, and preferably seven or more years.

Have A Reasonable Cashflow
A stable, regular income is essential to meet your interest expenses. You should never rely solely on dividend income.

Build In Some Flexibility
Don’t get forced into a position where you have to sell when you don’t want to. Build in some flexibility to cope with unexpected personal or job-related changes.

Seek Professional Financial Advice
Gearing can be very effective, but you should always seek professional advice to help develop a plan that suits your individual circumstances.