Q What are your thoughts on using a principal and interest unsecured personal loan for some light gearing in an Australian share index fund? Would the loan be tax deductible? Are there any other ways to gear and avoid margin calls?

A Gearing is the process of borrowing money to buy an asset. Gearing is often referred to as positive, neutral or negative. All terms refer to the nett cash flow effect. Positive gearing means the asset purchased after ongoing costs produces positive income or cashflow. Neutral gearing means the returns equal the ongoing servicing costs. Negative gearing means the ongoing costs are higher than income and hence produces negative cash flow. In Australia, provided the purpose of borrowing the funds is to invest into assets that generate taxable income, loan interest costs are tax deductible.

Gearing makes sense provided the long term rate of return is higher than the interest costs of borrowing. You need to weigh up the interest costs of the lending facility you choose and the flexibility in loan terms you require. The costs of gearing will depend on what type of loan facility you use.

Typically redrawing on a home loan offers the lowest interest rate cost. The asset securing the loan is your property as opposed to the assets you are borrowing to invest in. Lenders will typically allow you to borrow up to 80% of the value of your home without paying Mortgage Insurance. The other advantage of redrawing off your home loan is there will be no margin call.

Margin lenders usually lend up to 70% of the value of the investment assets securing the loan. A margin call occurs when the value of the assets falls to a point where the loan represents 80-85% of the value of the assets. A lender will require the loan to be reduced to an agreed percentage of the market value of the assets securing the loan. You can provide addition securities or pay down the loan. Margin calls can be avoided by maintaining a buffer of emergency funds to meet a margin call. As the investment assets secure the margin loan, an alternative is to limit the amount of borrowing to ensure there is sufficient buffer if assets were to fall dramatically in value.

An unsecured principle and interest personal loan is not secured by the investment assets and as such you will pay a substantially higher interest rate. The amount you can borrow will be determined by your credit record and your income. Lenders typically will limit the amount you can borrow to no more than $50,000. The time frame of the loan will be a consideration. For example if it is a 5 year loan, the repayments will be significant in order to pay out the loan over that time frame. Remember capital repayments are not tax deductible, just the interest costs.

An alternative form of borrowing is an unsecured Line of Credit. Whilst the rates may be higher than a principle and interest loan, you only need to meet the interest costs on a regular basis and no capital payments. The loan is unsecured and therefore there is no risk of a margin call.

“Light” Gearing would infer that you are not looking to borrow excessively so you can manage the risks of a Margin call by borrowing at a conservative gearing ratio. Other strategies to reduce risk and volatility would be to invest on a regular basis by dollar cost averaging. This smooths out the purchase price of assets.

Ultimately your decision should be governed by how long you intend to invest for, how much gearing you are prepared to take on, how healthy your cash flow is and how much of your capital you are prepared to commit.

Follow Andrew on Twitter @AndrewHeavenFP.  This article was originally published in The Australian.