The Benefits and Risks of Leverage
Leverage involves borrowing money to invest. This investment strategy is known as gearing. There are two main types of gearing:
1) positive gearing.
This is where the investment income that you generate is higher than any investment expenses, including the interest on the money you’ve borrowed to invest.
2) negative gearing.
This is where the investment income that you generate is lower than any investment expenses. Although on the surface that may sound like a bad investment, it can be an effective strategy if the capital value of your investment increases over time.
Negative gearing is a popular and common investment strategy in Australia, in particular with property.
It’s important to understand that there are both potential benefits and risks of using any gearing investment strategy.
Borrowing to invest can:
- maximise your returns because you’re investing more.
This is best explained using an example. Let’s assume you invest $120,000 and achieve an annual return of 5%. Your return will be $6,000.
However if you used that $120,000 as a deposit on a $600,000 investment and borrowed the remaining $480,000, an annual return of 5% means you’ll earn $30,000 before considering the cost of borrowing.
- reduce your taxable income.
If you borrow to invest, you can deduct the interest from your taxable income which will reduce the amount of tax you need to pay. For example, if you earned $30,000 in income in the example above but you were charged $24,000 in interest by your lender, you can deduct that amount from your income.
It is important to note that if you purchase an Investment Property you can deduct a range of other expenses from your income, including:
- property management costs
- repairs and maintenance expenses, and
- depreciation on appliances and furniture.
The potential risks of borrowing to invest include:
- interest rate rises.
Although interest rates in Australia are currently at record lows, they can rise as well as fall. If you’re borrowing to invest in property, it’s important to understand that it’s usually a long-term commitment to achieve capital growth. If interest rates rise, your loan repayments will also rise, and you’ll need to be able to afford them.
- losing money.
You’ll have to repay the amount you borrow (plus interest) regardless of how your investment performs. For example, you could lose your capital of you invest in shares and the company goes broke. If you invest in property, it’s important to understand that values can fall as well as rise. If you need to sell when this happens, you’ll lose money.
- your investment not generating the income you expect.
Share dividends aren’t guaranteed, and if buy an investment property, you may not always be able to attract tenants. It’s important to factor these risks in when you’re borrowing to invest. If you’re relying too heavily on your investment income to make your loan repayments, you may not be able to afford them if that income decreases for any length of time.
- your other income decreasing.
If you’re borrowing to invest, you need to consider how you would afford your repayments if you lost your job or were unable to work for an extended period of time if you suffered an illness or injury. Income protection insurance can protect you in this situation, so you should have this cover.
The bottom line
Borrowing to invest can be an effective way to grow your wealth, but it’s important to minimise and understand any associated risks. It’s important to seek professional advice before you do implement a gearing strategy.
How we can help
At Qi Wealth, our experienced, expert team of financial advisers can help you to take advantage of the benefits of leverage, while minimising the risks. We’ll take the time to understand your individual circumstances so that we can provide you with the best possible advice. We develop long-term, trusted relationships with our clients.
Contact us today to find out how we can help you!