Gearing or Margin Lending

Gearing is another term for borrowing money to invest. This facility allows you to use your existing investments to borrow additional funds and expand your portfolio. By doing this, you will have more money working for you in order to generate greater wealth for your retirement. It is a strategy designed to “turbo charge” your portfolio returns; however it is important to remember that it can also have the opposite effect if the borrowed funds are invested poorly.

Increased Risk to Investing

Although gearing is an excellent strategy to accumulate wealth, you must realise that investments may go up as well as down in value. You must therefore be aware that gearing can magnify gains as well as losses. Gearing increases the overall risk of your portfolio. It is, therefore, not a short-term strategy, but is more suitable for the medium to longer-term and investors with a higher tolerance to risk.

The term Negative Gearing arises when the cost of borrowing, interest cost of the loan, exceeds the income generated by the new investments. The net interest expense provides a tax deduction against the total income position of the investor. The full taxation benefit will depend on the prevailing interest rate and on the income yield of your investment portfolio.

Professional lenders such as Macquarie Margin Lending will provide a certain level of borrowing for each investment, expressed in percentage terms. The better the quality of the investment, the higher the lending ratio or percentage. As a guide, “blue-chip” shares will have lending ratios of 60 to 70%. A margin call will occur where the level of borrowings exceed the ratio provided, based on the assets that you have put up as security. Additional security will be required immediately or the lender has the right to redeem assets to restore the margin.

The difference between the interest paid and the dividends received needs to be made up in capital growth for the strategy to work. Therefore it is important that the borrowed funds produce an income or dividend yield.

Some basic rules:

Invest long-term. Do not enter into a gearing strategy with a short-term outlook. A minimum of three years is recommended to give your portfolio sufficient time to generate capital growth. Diversify your portfolio. Ensure your portfolio is well-spread and you are not heavily reliant on one single investment.

Invest in quality, income-producing assets. In order to meet the interest payments, it is vital that your portfolio produces income. Do the calculations on no income, e.g property with no tenant, and you will see our point.

Allow for interest rate rises. A portfolio proposal should be ”stress tested” for higher interest rate environments. Ensure that the differential between the interest expense and the income or dividends can be met from your surplus income. If you rely heavily on your salary for this, take adequate income protection insurance.

Maintain a comfortable margin ratio. We suggest a 50% lending ratio will ensure low probability of a margin call.

In order to maintain an acceptable level of risk, the portfolio should also be managed on an ongoing basis with reference to changes in economic conditions, market movements and specific investment opportunities that arise. Where necessary, the portfolio should be re-balanced to ensure that investment growth is maintained at an acceptable risk level.

Please note that Gearing is not appropriate for all investors and it is very important to discuss the above with your Adviser before entering into a gearing arrangement. Confirmation of any tax deductions and calculations should be obtained from your taxation adviser.