To invest, especially in large assets like property, you will more than likely have to borrow funds. Borrowing to invest in a share portfolio can also be a sound strategy.
Whether your first investment is in a property in which you live yourself (Yes, this can still be considered an investment!) or whether it is in a share portfolio, make sure you understand the basics of borrowing before you commit to taking on debt.
- Is borrowing to invest right for you?
- What does gearing mean?
- What are the benefits?
- What are the risks?
- Can I afford the repayments?
Often borrowing to invest is considered a risky venture but we all generally have to borrow to make our biggest investment, the one in our own home, so it is simply a matter of applying similar principles when we borrow to invest.
First though, let’s explore how borrowing to buy your own home works.
Generally a bank will lend you a certain percentage of the value of your house if you have sufficient funds to cover a deposit. Usually the house that you are purchasing will be held as security for the loan. What this means is that if you fail to make repayments on your loan then the bank can sell the house to recover the funds they have lent. You will need to consider whether you:
- Have enough saved for a deposit
- Can afford the repayments
- Can afford the other associated expenses.
This is a fairly straight forward process familiar to most people.
Borrowing to purchase other assets to hold as investments works the same way. You provide either cash for a deposit or other assets as security and are given a loan to purchase your investment (property, shares, managed funds, etc.) with the investment asset held as security for the loan as well. One of the main differences with this type of borrowing is that if the loan is used for income producing purposes (to buy a home that is rented out and produces rental income or to buy shares that pay a dividend) then generally the interest payable on the loan can be claimed as a tax deduction.
The issues that you need to consider before borrowing to invest in this way are:
- Do you have surplus funds you can use to make interest repayments?
- Will the investment be positive or negatively geared?
- Which type of loan will be the most suitable?
- Do you understand the risks involved?
- What are the taxation implications?
- What can be the benefits?
- What gearing ratio are you comfortable with?
You will often hear that an investment is ‘negatively geared’ but what does this, and the opposite’ positively geared’, mean?
Expenses to hold the asset including the interest repayments, are more than the income received, resulting in a loss situation.
Income from the investment more than covers all of the expenses relating to the investing, resulting in a profit.
You may ask why you would want to hold a negatively geared asset if it is making a loss. There are two main reasons:
- You may be entitled to offset any loss you make on one investment, against other income, resulting in tax savings.
- Over time, the capital growth of the assets means that you can sell the asset for a capital gain that more than covers the losses over the time held.
Other benefits of borrowing to invest can include:
- If the investment is positively geared you have access to a passive income stream that can provide you with greater lifestyle choices
- By borrowing to invest the capital growth potential of your assets is greater because of the greater capital base to begin with.
While the benefits of gearing into an investment are attractive, there are risks which you need to consider:
- Borrowing to invest can increase losses if the value of the investment drops significantly.
- You could be subject to a margin call if you have borrowed through a margin loan (explained in more detail on the margin loan page).
- By borrowing to invest in one asset such as an investment property, you may be reducing your exposure to a diversified investment portfolio.
- You may have limited access to your funds, if your investment is large and illiquid such as property.
As long as you are aware of the risks you can be prepared to manage them or wear the consequences. If you are unsure then talk to others or get some advice.
One final aspect of deciding whether to borrow or not is whether you can afford to make the repayments.
First of all you need to know whether you have any surplus funds available and this means some form of budget. Once you clarify what surplus funds are available there are a number of interest calculators (try any of the big banks) available to determine:
- How much you can afford to borrow.
- What the monthly repayments will be.
By taking the estimated income from your investment and your investment objectives into consideration you will be able to make informed investment decisions.
It is a rule of thumb that if you can’t afford the repayments on investment borrowing without relying on the tax advantages you probably should not be borrowing to invest. (Think of it as another way to help manage your risk!)
Never invest in something that you don’t understand and that includes investment loans of whatever type.
Never borrow to invest just for a tax deduction.