Borrowing to invest is not a new concept – many investors borrow money in their personal name or via a company or trust structure to purchase share market stocks, managed funds, real property and other investment assets. Borrowing to invest is often referred to as gearing, gearing up, negative gearing, leveraging and a range of other terms. In the superannuation context, a borrowing arrangement is often referred to as a limited resource borrowing arrangement (LRBA).
If you’re considering borrowing money to invest, then you’re probably a reasonably experienced investor who understands the relationship between risk and return.
If you have ever bought a home, and you have (or had) a mortgage, then you already understand the mechanics of buying an asset by using borrowed money. A mortgage involves the bank securing an interest against your property, in return for giving you cash to purchase that home, or potentially giving you cash for another home.
If you borrow money, then you must commit to making regular repayments into the future until you repay the loan in full. Even if the investment performs badly, and drops in value, you are still legally required to repay your loan commitments.
Gearing means Borrowing
Gearing is the term that is often used to describe investing in assets using borrowed money. The two most common forms of gearing are margin lending and negative gearing.
1. Margin lending
Margin lending is when you invest in shares using a loan secured against the shares you purchase. Many Australian financial organisations and stock broking houses offer margin lending facilities.
Margin lending, in the form of a margin loan, can be used for any type of investment product recognised as suitable security for a margin loan by the bank or financial organisation providing the cash. Typically, a margin lending product enables you to borrow money to invest in a parcel of shares, or in fixed interest securities or even to invest in units in managed funds.
Note: You can also invest in shares using borrowed money by borrowing against your home or accessing the equity in an investment property. By taking out a mortgage against your home or investment property, the shares that you choose to purchase will not be subject to margin calls although your home will be at risk if you’re unable to repay your loan. By accessing equity in a property, you can usually negotiate a lower rate of interest on your loan compared to the much higher rates charged on margin loans.
2. Negative and positive gearing
Negative gearing is the term normally used when you invest in property using a loan secured against the property, or secured against another property, and your expenses in running the investment property exceed the income (rent) that you receive from your tenants. The investment loss on the property can then reduce your taxable income.
When you purchase an investment property, you can claim most expenses incurred while you’re renting out the property, including interest payments on the property’s mortgage. If the costs of running the property are more than the income you earn from rent, then you declare a loss on your property investment in your tax return which in turn reduces the tax you end up paying on your non-property income.
Note: You can borrow to invest in property without incurring a loss on the investment. What this means is that the rent received from tenants covers all of the expenses incurred in running the property, including the interest repayments. If the running costs equally match the rent received, then such a property is considered to be neutrally geared. If the rental income exceeds the property’s running costs, then the property is considered to be positively geared.
3. Other forms of gearing
You can also invest in special geared products offered by financial organisations, although such products are generally only suitable for experienced investors. Examples of such products include instalment warrants and contracts for difference (CFDs).
If you run a DIY super fund (self-managed super fund), then you may be able to borrow to invest within your super fund using a ‘limited recourse’ borrowing arrangement.
Borrowing to invest in super is new. Until relatively recently this strategy was generally not available to super funds because the superannuation law prohibited borrowing except in limited circumstances. The law was amended from September 2007 to allow super funds to borrow more broadly, and subsequent amendments in 2010 have further clarified the capacity of super funds to borrow or invest. Today super borrowing is a popular strategy used by self managed superannuation funds (SMSF’s).
To find out more information about Borrowing to Invest, contact the team at Wise Accountants today on Telephone (08) 8364 3246 or email us at accountant@wiseaccountants.com.au to make a time to meet and discuss your options.