Is it worth borrowing money to invest?

Is gearing (borrowing money to invest) worth the risk? ASX analysts have found it does give higher returns, on average, than the equivalent non-geared investment – but there are a lot of things to consider before making the leap.

ASX report on gearing vs. not gearing

The ASX-Russell 2015 Long-Term Investing Report shows the following trends in long-term returns from gearing for investment. And keep in mind that this is simply reporting on history; there is no guarantee that future returns will provide a similar result.

Geared portfolios overall:

Geared portfolios gave larger returns in terms of franking credits for Australian investors at both the highest and lowest marginal tax rates, over both the 10-year and 20-year assessments. Non-geared portfolios showed smaller returns in franking credits.

Investment property:

Gearing gave larger returns on investment properties for both high and low tax brackets over 10-year and 20-year assessments. As an added bonus, rising property prices created higher long-term rental yields and capital gains in 2015 than in 2014, and the interest rate cuts created lower borrowing costs.

For investors at the highest marginal tax rate, geared investment properties gave better returns over 10 years than geared shares. However, for lower marginal tax rates, shares and investment properties gave equally good returns of 8.7%.

Over 10 years, gearing investors saw returns of 6.7% (low tax bracket) and 6.3% (high tax bracket), rather than 6.2% and 4.9% for those without gearing.

Over 20 years, gearing investors saw 10% and 8.7% returns, rather than 8.9% and 7.5%.

Australian shares:

Gearing allowed slightly better returns for both low and high tax bracket investors over 10-year and 20-year assessments. For investors at the lowest marginal tax rate, geared shares gave better returns than geared investment properties over both 10 years and 20 years.

Over 10 years, gearing investors saw returns of 7.7% (low tax bracket) and 5.8% (high tax bracket), rather than 7.4% and 5.3% for those without gearing.

Over 20 years, gearing investors saw 10.7% and 8.7% returns, rather than 9.7% and 7.6%. Please see the ASX-Russell 2015 Long-Term Investing Report for details on how these figurers were calculated.

Pros and cons of gearing generally

How it works

Gearing means taking out a loan to pay for an investment. It is a strategy used by many Australians, and in fact it would be impossible for most Australians to buy their own home without taking out a home loan.

Borrowing can allow you to earn more because you have more money available to invest. However, it can also magnify any losses: if your investment decreases in value, you still have to pay off your full loan, plus interest.

Why is it called “gearing”?

Picture the gears on a bike or a car. When you borrow to add more money to your investment amount, you have moved to a higher gear, so that the same effort on the pedal on your part creates more force than before and turns the wheel faster.

Pros:

  • The interest on a home loan or margin loan are tax deductible because they are costs “necessarily incurred” in earning the income that comes from your investment.

Cons:

  • If your investment decreases in value, you still have to pay off your full loan, plus interest. Any investment property should go up in value before you need to sell it.
  • If you borrowed to invest in shares, and your shares go down in value past the LVR, you will have to pay a margin call.

The bottom line for investors

Ultimately, the decision on whether or not to borrow for investment is yours to make, based on your personal situation and preferences.  Here are a few basic things to consider:

  1. Get independent tax and financial advice before making any investment gearing decisions.
  2. Make sure that you have enough savings to cover a period where you don’t have a tenant or where you have to pay a margin call.
  3. Check our comparison website to find a home loan or margin loan with a low interest rate and the features you need.
  4. Consider landlord insurance for an investment property, and income protection insurance, at a minimum. Ideally, discuss your personal insurance needs with your financial planner.

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