Q. Dear coach, we’ve been reading about possible changes to negative gearing – almost embarrassed to ask…what is it? Does it work for everyone?
A. Gearing is the process of borrowing money to buy an asset. Gearing is often referred to as being either positive, neutral or negative. Positive gearing means the asset purchased after ongoing costs produces positive income or cash flow. Neutral gearing means the income equals the ongoing costs. Negative gearing means the ongoing costs are higher than income and hence produces negative cash flow…
Gearing can potentially be an effective way to accelerate the accumulation of wealth. The benefits of gearing are that larger investments can be made by borrowing than if you were only using your own funds. There is potential for greater investment returns (after taking into account tax and other costs) than would be achieved without gearing and the strategy may also help reduce your ongoing tax liability.
Provided the purpose of borrowing the funds is to invest in assets that generate taxable income, loan interest costs and costs associated with borrowing are generally tax deductible. There may also be potential tax benefits available to offset tax on the investment return. For example, depreciation on property and furnishing, the 50% Capital Gains Tax discount on the sale of the asset if owned for more than 12 months by and individual and franking credits on ongoing share dividend income.
Gearing exposes you to additional risks that need to be taken into consideration before embarking on the strategy. Gearing increases the investment risk attached to an investment because the borrowed amount increases your exposure to an investment market.
Whilst gearing provides an opportunity to increase gains when markets are rising when markets fall, losses are magnified. This means that although as an investor you might receive extra tax deductions over time, you might actually lose capital value and carry over significant debt when you eventually sell the asset.
Gearing is only appropriate for people with sufficient cash flow/income to meet ongoing borrowing costs. You should only borrow to invest if you have the financial capacity to absorb potential falls in investment values, periods of lower or no rent on a property. Likewise, you need to be able to weather the impact of rising repayments if interest rates were to rise.
Investors need security of personal income. A loss of income or change in personal circumstances, even if temporarily, could cause cash flow problems that may require the sale of an asset or part of an investment portfolio at an inopportune time which may lead to investment losses.
Gearing makes sense provided the long-term rate of return is higher than the interest costs of borrowing and the costs of managing the asset. The costs of gearing will depend on what type of loan facility you use. Typically drawing on a residential property loan offers the lowest interest rate cost. Lenders will usually allow you to borrow up to 80% of the value of your property without paying Mortgage Insurance. You need to weigh up the interest costs of the lending facility you choose and the flexibility in loan terms you require.
Ultimately your decision whether to borrow to invest 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.