Borrowing to Invest

You may be considering borrowing for investment purposes with the view to having a long term share based investment in place. Share based investments should be seen as long term so that you can ride out the volatility, or the ups and downs in the markets. It would be too risky to use share based investments to try and achieve short term goals. In the short term you may find that your investment declines in value, leaving you in a position where you are unable to fund your requirements.

Ethical Investment Services can recommend a borrowing facility for you to use if you wish. Once this process is complete, we can implement any investment recommendations. 

Gearing

A leveraged or geared investment is the buying of an investment asset using borrowed funds. Borrowing to invest gives you the opportunity to increase the size of your investment and therefore the potential return. In doing so you hope to achieve a higher return or capital gain than if using only your own funds. Over time, your equity (i.e. ownership) in the borrowing program will rise and with growth being the primary component of your returns from this portfolio, any tax liability will attributable to capital gains.  Capital Gains Tax (CGT) is deferred until the assets are sold and the growth is actually “realised”. A carefully selected investment in quality, managed funds, which invest in growth assets such as Australian shares and property, will also provide significant tax benefits through dividend imputation and tax-deferred income.

Interest and related borrowing costs are usually tax deductible.

Negative Gearing

Negative Gearing takes place when the cost of borrowing the funds to invest is greater than the income from the investment. You can claim a tax deduction for the interest expense of a loan which is generating some income for you. If for example you borrow $20,000 at 9% interest and invest in a managed fund of share investments the interest expense will be $1,800 per year. If the investment returns 4% income, lets say $800, you can claim the $1,000 difference as a tax deduction. In effect your taxable income will be reduced by $1,000. Therefore the impact of negative gearing is greatest for those paying the top marginal tax rate. In this example, for someone on the highest marginal tax rate, the tax saving would be $1,000 x 45% or $450, but remember you had to pay $1,000 of your own funds to service the loan.

Although negative gearing may seem attractive from a tax perspective, remember the higher the negative gearing aspect, the more of your own funds you will have to provide to service the loan. If you borrowed funds to invest and you were then exposed to either an increase in interest rates or a downturn in the market, you may find yourself in a difficult situation. You should consider this carefully. If after fully considering the above risks, you are still keen to start a geared investment, I would suggest you limit borrowings to an amount which would not threaten your existing assets or current lifestyle if things turned sour.

Significant Risks Associated with Borrowing to Invest

We emphasise the fact that although there are significant benefits associated with gearing, there is also a proportionate amount of risk.  You should carefully consider the following aspects:

You must allow a generous margin in your ability to service the loan repayments to cater for a rise in future interest rates.  The fact that interest rates are subject to fluctuation can cause some difficulty in servicing the loan over the longer term because it is difficult to predetermine what your repayments and cashflow requirements will be.

A decline in the value of your investment portfolio will increase the relative amount of borrowings against your total portfolio.  However, as long as the investments are of long-term quality with the prospect of good future cash flow and capital growth, it is prudent to hold the investments through different market cycles.

A decline in the value of the investment portfolio will lead to a paper loss if the portfolio has to be sold. While your investment horizon is for the long term, if circumstances forced a shorter-term outlook we would have to revisit your position and possibly restructure your investments to help preserve your capital.

Your need for certain types of personal insurance policies (eg. income protection) will increase significantly.  You will be implementing a long-term wealth accumulation strategy that includes an ongoing commitment to servicing a loan contract.  Your ability to service this loan is largely dependant on your ability to earn income and you need to consider making appropriate arrangements to ensure that you will be covered if you are injured and unable to work for an extended period.