Gearing simply means borrowing money to invest. Gearing may be used with existing savings to accelerate the process of wealth creation by allowing an investor to make a larger investment than would otherwise be possible. The borrowed money can be invested in a number of ways, including direct shares, property and managed investments.
Negative gearing occurs when the interest payable on borrowed funds exceeds the net income received from the investment. The investor must have surplus income over and above their day to day living expenses to meet the shortfall. Gearing can be an effective strategy if the after tax capital return of the geared investment exceeds the after tax costs of funding the investment.
In order to determine you have sufficient funds in retirement you will need to focus on a wealth creation strategy through adequate investments to fulfil your medium and long term financial goals. One way is that you set up a margin loan facility. This will allow you to ‘gear’ your existing financial position by utilising borrowed funds to gain greater exposure to the investment markets. It is also very important that you understand not only the benefits of margin lending through gearing, but also the potential risks.
The strategy involves borrowing money to invest. The advantages of gearing are: that interest on the borrowing may be tax deductible against any income earned from the investments, and the borrowings provide a larger capital sum to invest and earn returns. For gearing to be worthwhile, the total investment return must be higher than the interest expense after tax.
Gearing increases the risks of the investment because should values fall, not only will the initial capital and the borrowed funds lose value but the full value of the borrowing will still have to be repaid.
Gearing should only be undertaken by investors who are committed to investing in growth assets for the long term and who have sufficient surplus cash flow to meet interest repayments or a margin call
Under margin lending, the loan is secured against shares and property trusts listed on a stock exchange and unlisted managed funds. Some of these will be existing investments, which represent the borrower’s equity, with the balance being new investments purchased with proceeds of the loan. (An example is set out below)
Margin Lending is offered by many banks and other finance providers including stockbrokers. The lender provides a list of the specific securities that it will accept, and nominates a percentage of the market value for each security, which is the maximum amount that it will lend against that security. The interest rate is normally higher for margin lending than for a property loan. Establishment costs can be lower than for property Loans.
The list of securities provided by the lender should be checked by the financial planner, as any investment made outside this list cannot be used as security for the loan or to satisfy a margin call.
The loans are normally arranged as a line of credit and are very flexible. They do not normally specify a repayment that must be made; the only requirement is to satisfy a margin call if the level of security falls to low. Repayments can be made on a regular or ad hoc basis, or the income from the investments can be credited to the account. Interest will be debited to the account and, if not paid, will be capitalised as part of the loan balance. If repayments from all sources do not cover interest the amount of the loan will increase, which could lead to margin calls.
Loans can be partly or fully repaid and subsequently redrawn with a little, if any, cost. This can be done on a regular basis, which allows the borrower to take advantage of opportunities to sell or buy investments on short notice. If the investor is active in buying and selling shares or other investments, settlement for each trade can be made by debiting or crediting the investor’s margin lending account – provided only that the balance remains within the borrower’s approved credit limits, including the value of investments used as security for the loan.
Margin lending is normally “non-recourse”, meaning that in the event of default on the loan, the lender only has access to the specific assets given as security.
It is critical that anyone taking out a margin lending loan fully understands the way in which it operates, including the possibility of having to make a margin call. Margin Calls are normally payable within 24 hours. All borrowers must be able to satisfy any margin call within this time.
The list of acceptable securities may include some investments for which the deductibility of interest is in doubt in some circumstances. A possible strategy is for these investments to be acquired using specifically non-borrowed funds only. Any residual amount of the non-borrowed funds could then be used, together with the borrowed funds, to purchase investments for which the deductibility of interest is not in doubt.
The tax advantages of using a third party security provider on a lower tax rate are available under margin lending.
Scott wishes to develop a $75,000 investment portfolio from savings of $30,000 using margin lending. The savings of $30,000 are invested as $10,000 into an international share fund and $20,000 into a diversified managed fund. These investments are then used as security for a margin lending loan. The lending margin for both funds is 60%. $45,000 is borrowed under the margin lending loan with $30,000 invested into an Australian share fund and $15,000 directly into CBA listed shares. The lending margin for each of these new investments is 70%.
|Portfolio Value $||%||Margin Value $|
|Australian Share Fund||0||70||0|
Safety Margin = 1 – $0 = 100%
$10,000 + (5% x $30,000)
Purchases using Margin Lending
Australian share fund CBA
$ 30,000 15,000
Portfolio Value $ %
Margin Value $
Australian Share Fund
CBA 15,000 70
Safety Margin = 1 – $45.000 = 15.49%
(new portfolio) $49,500 + (5% x $75,000)
6,000 12,000 21,000 10,500
10,000 60 20,000 60 30,000 70
Scott’s total portfolio is now worth $75,000, the margin value is $49,500 and the loan is $45,000, giving a gearing level of 60% and leaving available funds of $4,500. The safety margin is 15.49% – this is the maximum percentage that the value of the assets can fall before a margin call would be required. The safety margin includes a 5% buffer which is allowed by most margin lenders. The 5% buffer means that for a security with a lending margin of, say, 70%, the lender will allow the loan to grow to 75% of the value of the security before making a margin call.
Some margin lending facilities have a regular or instalment gearing or savings option. For practical reasons investments may be restricted to managed funds, but the initial investment can start from approximately $3,000 – equity of $1,000 and borrowing of $2,000. The investor then increases the equity by regular monthly amounts which are matched $2 for $1 (or the agreed proportion) by borrowed funds, subject to the credit limit approved for the borrower.
This could be a convenient way to start accumulating geared investments by instalments – although expenses and the interest rate are likely to be higher because of the small amount of the loan in the early years.
The borrower must satisfy a margin call (usually within 24 hours) or the lender can sell a sufficient quantity of the assets lodged as security to satisfy the call. A margin call can be satisfied by:
- Lodging further assets as security
- Lodging cash or other funds to reduce the loan or
- Selling assets and using the proceeds to reduce the loan.
If at anytime the current loan-to-security ratio is equal to or exceeds the margin call loan-to-security ratio, then you must act within the time period specified in Clause 1 to ensure that the current loan-to-security ratio does not exceed to base loan-to-security ratio. You can do this by giving us a security interest over some additional securities that is of a type and in form acceptable to us, or by repaying part of your loan, or both. If you are using a Regular Gearing Facility and choose to meet a margin call by repaying part of your loan, then this does not affect your obligation to continue to draw all the amounts you have agreed to borrow from us until you reach the credit limit. If you choose to repay part of your loan to meet a margin call, then a prepayment fee may apply.
Risk of Excessive Gearing
In practice, geared investments could use a combination of a property loan and a margin lending loan (e.g. $250,000 could be borrowed as a property loan against the security of a house and invested. These investments could then be used as security for margin lending of $500,000 which is also invested. The total amount invested is $750,000, which is all derived from the borrowed funds).
However, discipline must be exercised. The investor and all other security providers must understand the borrowings arrangements and liabilities involved. In addition, the total level or borrowings must be kept to a reasonable level having regards to the financial position of the investor.
The benefits of gearing are:
- Income from the investment can be used to offset the cost of borrowing.
- You will have greater exposure to investment assets.
- In favourable market conditions the exposure can multiply your potential earnings.
- There may be some positive tax implications depending on your personal situation and the return of your investments.
The risks associated with gearing are:
- Your increased exposure may multiply your potential losses during unfavourable market conditions.
- Your investment may not provide the growth and income that you expect.
- Increased interest rates may effect the cost of borrowings.
- A significant fall in the value of your assets with certain levels of borrowing may trigger a situation where you will be expected to provide extra funds with the margin lender through a ‘margin call’.