Gearing is where you borrow money to invest. As already mentioned, it is best to clear all your debt before looking at investment. However, there will arise situations where the investment is a good one and it is necessary to borrow a small amount to make the deal work. The borrowing may be for property or shares.
Gearing allows you to increase your investment and potentially obtain a higher return. On the downside, however, if the investment does not pay off you stand to lose a lot more. Negative gearing comes about when the interest you are paying on your borrowing is greater than the income from your investment (for example, from a rental property). You can claim the loss or difference against your taxation and write it off as a deduction against other income.
Negative gearing is not necessarily the best investment strategy. Even though you get a tax break it is still costing you money. That is, you may be saving yourself 25 cents in the dollar, but you have to spend one dollar to achieve that.
People look at negative gearing because they calculate that they will be able to sell the investment for more than they bought it and in the meantime their losses are deductible off other income they earn. They conclude that the Commissioner of Inland Revenue is in reality helping them fund the growth of the value of their property.
If it can be avoided, don’t borrow against your home for investment. This applies particularly when the investment is speculative. Things do go wrong and you wouldn’t want to find yourself (and your family) out on the street without a roof over your head.
If you borrow money to invest, this is known as margin lending. The extra funds raised allow you to invest more, increasing the potential returns, compared to what you would get from your standard savings. It allows you to use other people’s money so you can get a significant increase in your wealth from a small deposit.
The negative side is when share prices fall below a level and a margin call is made. When this happens you will have 24 hours to respond in one of three ways. You have to come up with the cash, you have to sell assets, or you have to provide additional assets to top up the equity.
If you have a margin loan, make sure you fully understand the terms of your loan and also put in place survival strategies in case things don’t work out.