Borrowing money to increase the amount you have to invest with is called gearing or leveraging. It also provides an opportunity to increase diversification.

While it can increase, or magnify your returns when markets are rising, losses can be bigger when markets fall because you’re forced to sell an investment at a bad time.

The most effective investments for gearing are those which offer the greatest potential for growth – direct and managed shares and property.

By ‘direct’ we mean you manage and own it in your name, and can sell it whenever you want (regardless of whether someone wants to buy it). Common ones include an investment property or bank account.

Because growth assets need to be held for more than 7 years, gearing isn’t appropriate for short term goals like saving for a car you want in 6 months. Gearing is generally a medium to long term strategy (at least 5 to 10 years).

The tax benefits available are most useful if you’re on a higher personal tax rate (37% or higher) and suits those with a greater tolerance of risk (a risk profile of Assertive/Growth or Aggressive/High Growth if you’re borrowing a lot to invest).

However, borrowing to invest only makes sense if the investment return (after tax) is greater than all the costs of the loan, such as interest and fees. If not, you’re taking on a lot of risk for an overall low or negative return.

You should also consider:

• Extra cash to meet loan repayments if negatively geared or using margin lending facilities.
• If investment markets fall, the amount you owe might increase and the lender could ask you to reduce this by making an extra payment.
• This is known as a ‘margin call’ and if you can’t pay, your investment will probably be sold by the lender - you get what’s left.
• Appropriate levels and types of personal insurance to protect your ability to meet repayments if you can’t earn an income.

To gauge the risk of the loan, lenders use a loan to value ratio (LVR). The LVR is the amount you borrow divided by the total value of your investment used as security.

Most margin lenders require you to keep the LVR below a maximum of 70% - more details are in the Margin lending section.

LVRs for property loans are usually higher but you may pay for things like lenders mortgage insurance (for LVRs above 80%).

If you’re investing with money from an offset account attached to your mortgage, there may be tax benefits such as deductions for interest payments on the loan. You’ll need to obtain tax advice to work out if this applies to your situation.

To gear not to gear

Gearing aims to increase your wealth with the use of borrowed money. Borrowing can magnify the investment outcome that would otherwise be available with just your own funds.

The aim of gearing therefore, is to increase your investment return by more than simply investing with your own money.

Let’s see this in action using Izzy as an example.

As you can see from the example above, gearing can be a two-edge sword.

Gearing can increase gains from investing but can also magnify losses. If considering gearing, do so with your eyes wide open.