Gearing for success may sound contradictory, but it could be the right strategy for your personal wealth creation.
By Jack Meagher
Using debt to build wealth may sound like a contradiction in terms, but a robust debt strategy can be used to accelerate the process of wealth accumulation by enabling you to make larger investments than would otherwise be possible.
In financial terms, borrowing money in order to invest is called gearing. Gearing simply means there is some type of loan involved in the investment.
It is important to borrow sensibly because while gearing can amplify your gains, the type of investments suitable for gearing can be more volatile than others and also lose value. If this happens, gearing will magnify your losses. In other words, the more you borrow the more you stand to gain or lose and the higher the borrowings, the higher the risk.
No matter how strong an investment opportunity appears to be, your gearing strategy should be prudent enough to offer protection from being forced to sell during a low point in the investment markets in order to obtain the benefits of long term growth.
Types of Gearing
Positive gearing is where you borrow money to invest and the income from your investment is higher than your interest costs and other expenses.
Negative gearing is where you borrow money to invest and the income from the investment is less than your interest costs and other expenses.
Neutral Gearing is where you borrow money to invest and the incomefrom the investment is equal to your interest costs and other expenses – in other words you’re breaking even.
How and whether you can use gearing will depend on your own particular circumstances.
Generally speaking, a geared investment:
- needs a reliable cash flow to cover pre-tax borrowing costs
- has an investment timeframe of at least five years to make the most of the investment’s potential to build wealth
- generates a reliable, long-term income
- generatescapital gains, i.e. an increase in the value of your investmentsover time
Using debt effectively
The foundations of implementing a successful strategy requires an understanding of the difference between efficient and inefficient debt.
Efficient Debt is used to acquire assets that have the potential to grow in value and generate assessable income. The loan interest is tax deductible and the income generated by the asset can help to repay the debt. This makes it more easily serviceable and a useful tool to accelerate the creation of wealth. An example of efficient debt is an investment loan to buy shares or property.
Inefficient Debt is used to buy goods, services and assets that generally don’t generate an income. You can’t claim the loan interest as a tax deduction and need to rely on your own resources to service the debt repayments. An example of inefficient debt is a personal loan to buy a car or credit card debt that is not repaid within the interest free period. These forms of debt can be draining on cash flow and offer no real long term benefits.
Home loans are generally less efficient and wherever possible you should try pay them off as quickly as you can. Increasing repayment frequency, increasing the repayment amount or even crediting your salary automatically into your home loan or offset account could save on interest costs and importantly, create equity in your home that could be put to work growing your wealth.
Borrowing against the equity in your home
There are many benefits to this approach, the most pertinent one being that you are able to invest across multiple asset classes at a lower rate of interest than other forms of debt. This is because you’re using your property as security, meaning you pose a lower risk for the lender. It also allows you to use as leverage the capital gain of the property, which you couldn’t otherwise do without selling it.
From a risk perspective, it’s important to recognise that when you borrow against the equity in your property, your overall level of debt increases. This means you have more financial responsibility and permits the lender to repossess the property should you be unable to meet the increased loan repayments.
The concept of borrowing against equity in your home also allows for what is known as debt recycling. This involves replacing inefficient debt with efficient debt and thus establishing an investment portfolio to help build your long term wealth.
There are three basic steps to implement a debt recycling strategy:
- Use your equity as security for a separate investment loan.
- Use the investment income and any tax savings you receive from your investments (as well as any surplus cash flow) to reduce your outstanding home loan balance.
- Throughout the year, re-borrow from your investment loan the amount you have paid off your home loan to purchase additional investments.
The benefits of successful debt recycling compound over the long term and include a reduction in personal tax and paying down your home loan quicker, while building additional investment assets and an income stream. On the other hand, you will still have debt (albeit deductible debt) and your level of risk is increased. This is a long-term strategy and one that you need to be prepared for short-term fluctuations and market volatility.
When taking on debt be sure to keep in mind the following:-
- Don’t over-extend yourself.
- Invest in quality growth assets which are able to deliver the higher potential returns required.
- Invest for the long term to give your investments enough time to generate adequate capital growth.
- Have adequate insurances in place to help meet any debt commitments should you be unable to work due to illness or injury
- Ensure you seek professional advice to understand whether gearing is an appropriate and viable strategy for you and your particular needs.
For a review of your existing debt, to discuss future requirements or to understand how you can obtain financial independence sooner contact Jack Meagher on 0456 963 339 or [email protected]
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