If you’ve been listening to the Financial Autonomy podcast for a while, and particularly if you’ve had a chance to pick up the Financial Autonomy book, you will be aware that we work to a proven framework. Within the Financial Autonomy framework there are three pathways that can be followed to get you to the point of gaining choice. Those three pathways are investing in stocks, investing in property, and starting a business or side hustle.
Today we’re going to explore a strategy element that has application to both the stock and property pathways. We’re talking here about the gearing. Gearing means borrowing to invest. Magnify your investment outcome by using someone else’s money. Gearing is a way to increase your risk, and we know that risk and reward are inextricably linked. We also know that there’s no such thing as a free lunch, and higher risk, whilst helpful in providing the potential for higher returns, also comes with the potential for greater loss. So in this piece we will be looking at how you might manage the risk associated with gearing too.
Why borrow to invest?
Borrowing to invest, what we call gearing, magnifies your investment outcome. The benefits can most easily be seen with a simple example.
Let’s say you had $50,000 available to invest for 10 years. Were you to invest this without gearing, and it earned 10% per year, it would grow to almost $130,000, meaning you had gained $80,000 – $130,000 less the original $50,000 that you invested.
How about, instead, you matched your $50,000 with another $50,000 of borrowed money, so now you invested $100,000 and let it run for 10 years, again earning 10%.
Now the portfolio grows to almost $260,000. You need to pay back the $50,000 that you borrowed, and you also need to pay interest on the borrowing. Once you do this though, you are left with about $174,000, or a gain of $124,000 given you put in $50,000 of your savings to begin with.
So the same investment time frame, the same return (which tells you the same amount of investment risk), but the geared portfolio produced $44,000 more in profit before tax. That is a meaningful difference.
All the way back in episode 25 I shared how I got lucky with the first property I ever bought, making a return of 68% per annum. This result was in large part due to gearing. Without gearing I never would have been able to buy the property, but even setting that aside, the growth on the investment was 15% per annum. A great result, but a long way short of the 68% I got because of the leverage gained through borrowing.
It’s important at this point to balance the ledger a little bit and highlight that gearing strategies have the potential for losses as well as gains. As mentioned at the beginning, gearing magnifies investment outcomes. That magnification applies to both positive outcomes, and negative outcomes. If you borrow to buy an investment, and the value of that investment decloans, you still need to pay your lender back what you borrowed. As a result any investment strategy that contemplates gearing needs to be well thought out with risk management strategies built in.
Gearing into Property
Borrowing to buy a property is the best-known example of gearing. Whether it be a property for you to live in, or a pure investment, most of us won’t have enough savings to buy a property in an all cash transaction.
Property lends itself well to gearing strategies because banks are very comfortable lending against the value of property and taking that property as security should you default on the loan. In some cases where you have considerable equity in your home, it may be possible to borrow the entire purchase price of the investment property, with the bank using your home as additional security. Such a transaction provides enormous leverage provided the value of the property increases over time. Other than a few transaction costs, you’ve put no money into the transaction, so any appreciation in the value of the property is a pure gain. Of course there is interest costs on the loan, but typically the rental income that the property will produce is enough to cover these costs.
Lenders Mortgage Insurance
If you have ever bought a property, you will be aware that Lenders Mortgage Insurance can be a significant cost. This is insurance that the banks force you to pay, but which actually only protects them. Were you to default on the loan the insurance will protect the bank in the event that the sale of the property doesn’t produce enough money to fully repay your debt.
Lenders mortgage insurance only typically applies where you borrow more than 80% of the property value. The cost of this insurance increases the higher proportion of the property value that you borrow. So for instance, if you borrowed 95% of the value of the property, you would pay higher lenders mortgage insurance then if you borrowed 85% of the value of the property. This has some logic to it. In the 85% scenario you have put down a 15% deposit. That is effectively a 15% buffer between the value of the property and the amount of debt. If the bank had to sell the property to clear your loan because you could no longer pay it, the value of the property could decline by up to 15% and there would still be enough there to clear the debt to the bank. With the loan at 95% of the value of the property, there is only a 5% buffer that the property could decline in value by, before there wouldn’t be enough value in the property to clear the debt.
This means that the larger deposit you have, the more you can save on paying lenders mortgage insurance. And indeed if you have a 20% or more deposit then you can avoid this cost altogether. It’s a juggling act though because it takes time to save the deposit and often in that time the value of properties rise. So you can end up having to pay more for the property, than perhaps you would have if you jumped in quicker and copped the insurance costs on the chin. Always a tricky one, but something to consider.
Gearing into Stocks
Whilst borrowing to buy property is very well accepted, borrowing to buy stocks is a far less considered option. It’s a curiosity that I cover in some detail in the Financial Autonomy book. Borrowing to invest in stocks has a number of advantages. You can invest smaller amounts, you can be far more diversified, you can liquidate quickly if your circumstances change, and there are far less costs associated.
Once, the primary way investors borrowed to purchase stocks was through a product called a margin loan. Margin loans still exist and indeed we have several clients who still have them and manage them well. But poorly managed, margin loans can be a disaster. I think this is where some people have been scared off gearing into stocks. When markets fall sharply, margin loans can force investors to sell, a terrible course of action in a market downturn that locks in losses. This can be prevented with appropriate management, but as so often happens it only takes a few bad outcomes too taint the waters.
Fortunately, today, there are alternatives to margin loans for those looking to gear into shares. For investors with equity in their home, frequently the best way to go is to take out an investment loan against their property. This is typically very low cost, the loan term is long, and there is no risk of a margin call.
There are other solutions that don’t require home ownership, where the investment loan requires regular principle payments so the amount of debt is constantly reducing, providing the lender with increasing comfort over time. Such solutions also do not have margin calls.
What is Negative Gearing?
Negative gearing is a term you hear bandied about a lot. I find that some people consider it a bit mythical, some special secret that gives those in the know free money. In fact negative gearing simply means that from a cash flow perspective, you are losing money on a regular basis.
If you consider borrowing to buy an investment property, which is where you most often hear the negative gearing term, in a negative gearing situation you do not receive enough rental income to cover the interest costs of the loan that you took out to buy the property.
Right now, negative gearing is increasingly rare, because interest rates on loans are so low. But the idea with negative gearing is that the loss you incur is able to be written off against your other income, typically your wages, and in that way it reduces your tax.
There’s no magic to it though, you are still losing on a consistent basis and still have to find the cash to cover the shortfall between the rent and the interest expense. The only way negative gearing produces a good outcome for you is if the value of the property increases enough over time to more than cover what you’ve lost from a cash flow perspective.
An investment where the income exceeds the interest costs on the loan would be called positively geared. In this scenario, you could use that surplus to reduce the amount of debt that you owe, or use it for some other lifestyle or investment purpose.
Managing Risk when Gearing
As already mentioned, gearing magnifies investment outcomes, both positive and negative. So what can you do to minimise the chances of you having a negative investment outcome?
The most obvious is having an appropriate investment timeframe. Data recently produced by Katana Asset Management found that over the 146 years that the Australian share market has been in operation, an investor who mimicked the market, and held their investments for eight years or longer, would have never had an instance of losing money, once dividends are factored in. Over a 5 year time frame, there were only 7 times where a negative result would have occurred.
Now of course, just because that was the outcome in the past, doesn’t mean that it will necessarily be the outcome in the future. It does however point to the major way you can minimise your risk when embarking on a gearing strategy. Don’t undertake this strategy unless you have a long time frame. The longer the better, and certainly the minimum time frame would be five years.
Next, don’t be too aggressive with the ratio of borrowings to cash that you put in. In the example earlier we had the investor with $50,000 borrowing an equal amount to create a $100,000 portfolio. Such a portfolio is therefore geared to 50%. That is, half the portfolio is debt and half the portfolio is the investor’s savings. Should the value of the portfolio drop in value, it has to go down a very long way before the investment isn’t worth at least enough to pay off the debt.
A conservative gearing ratio along those lines can also mean that the cash flow is more easily able to cover the loan costs. So in this case you have a $100,000 portfolio producing income, but interest costs on only a $50,000 loan. Particularly in the current low interest rate world, such an arrangement would be highly likely to be positively geared, which increases the chances that you will be able to retain the portfolio for the long term, and as mentioned above, that is the number one way in which to produce a positive investment outcome via a gearing strategy.
A final thing to consider when looking to reduce risk for gearing strategies is to have appropriate income protection insurance. Again, what we want is for you to be able to retain this investment for as long as possible. One reason you might be forced to sell is that illness or injury causes your income to drop, and you could no longer service the debt. Having appropriate income protection insurance in place can protect against this outcome.
When is the best time to use a Gearing Strategy?
So when is a gearing strategy appropriate? I think the first cab off the rank is that you have stability your employment situation. As mentioned multiple times already, gearing strategies must be long term investments. That being the case, what we don’t want is to embark on a strategy, you lose your income, and the strategy needs to be wound up far earlier than envisaged. In such a scenario, losses are far more likely.
The next prerequisite would be to have a solid personal balance sheet. I would never recommend a gearing strategy to someone who was carrying credit card debt and didn’t have an emergency fund set aside. As with a stable income, this is about being able to ride the normal ups and downs of investments. You never want to be a forced seller.
Gearing is usually best for someone who has had some investment experience. It’s all very well to say that market volatility doesn’t bother you if you’ve never lived through it. We generally wouldn’t recommend a gearing strategy to someone unless we can see that they have experienced the normal cycles of investment markets, and shown they are not someone who panics or flip flops due to short term noise.
Finally, you want to have reasonable clarity about your future. This investment strategy that you are about to embark upon needs to run for at least five years and ideally 10 or more. If your life is in a state of flux and you can’t be sure that you will be able to hold the investment for this duration, then gearing is unlikely to be an appropriate strategy for you.
Gearing to invest is an advanced strategy and I would encourage you to obtain advice should this be a path that you want to go down. Whilst Australians often consider borrowing to invest in property to be something of a no brainer, I encourage you to also consider borrowing to invest in stocks, and whether this might actually be a lower risk and more accessible strategy option for you. If you want help, check out the Advice page on the Financial Autonomy website.
General Advice Warning
The information in this piece in general in nature only and is not personal advice. Gearing is a higher risk strategy with the potential for loss. You should seek out advice that is specific to your circumstances before embarking on such a strategy. See our full general advice warning here.
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