Investment gearing explained... Gearing is the use of borrowed money, secured on existing assets, to partly or wholly finance the acquisition and ownership of
another investment.

Gearing is simply borrowing to invest. If successful and well managed, gearing can accelerate wealth creation. If unsuccessful and poorly managed, it can and often does lead to significant financial loss.

To be successful, it is essential that one only gear into investments that are thoroughly researched and which can be reasonably expected to provide substantial capital growth in the medium to long term. In the case of shares and managed funds, one should ensure adequate diversification and quality investment management.

Successful and well managed gearing also involves the use of adequate life insurance and income protection insurance to protect the investor and his / her dependants by ensuring that the investor is likely to be able to meet interest repayments (and margin calls when margin lending is used) at times when sickness, accident or death halts regular income.

Additionally, one should also carry a reasonable cash reserve to meet any increase in interest costs or margin calls and to ensure that the investments do not need to be liquidated during market lows.

Borrowing money for investment purposes can be
a means of accelerating the wealth creation process as you have a larger pool of funds working for you. The principle goal is to ultimately have the return on investment (growth plus income) substantially exceed the total costs of borrowed funds.

Under current tax legislation, the interest cost may be claimed as a tax deduction only if the borrowed funds are used to buy an income producing asset. Interest on borrowings used to invest in superannuation or insurance bonds is not deductible. The tax deduction available on interest costs is often seen as the most important immediate benefit of gearing. However it is
to no avail if the underlying investment fails to increase in value or produce adequate income.

Investment gearing should be regarded as a long term strategy. A minimum term of 7 years or more is recommended for any geared investment to ride out adverse market conditions which might occur at any time.

How to gear to invest

Home Equity, Margin Lending and Internal Gearing are three methods of gearing. The type of gearing depends on the equity supporting the loan and the source of the borrowed funds.

Home Equity
Home equity gearing involves the use of a home equity loan or a line of credit as a source of funding. This type of lending is usually done on variable interest rates however it is possible to use a fixed rate which allows you to prepay a full year’s interest in advance in June of each year which is fully tax deductible in the year the interest is paid.

Margin Lending
A Margin Loan is a facility that allows you to borrow to invest using cash, shares and/or managed funds as security and is suitable for non home owners or for those who do not wish to use their home as security.

The amount you can then borrow is dependent upon the borrowing limit applied to your existing investments and the investments you wish to purchase. The downside to Margin Lending is that if the value
of the investments falls the lender may issue a Margin Call. Because of market volatility the market value of a geared portfolio will fluctuate daily causing the loan to valuation ratio (LVR) to rise and fall. To avoid making margin calls every time the LVR exceeds the maximum limit, the lender will generally impose a buffer before a margin call is made.

The time for meeting a margin call can be as little as 24 hours. Failure to meet a margin call will result in the lender selling a portion of the investments to restore the loan to security value which may crystallise a capital loss.

To avoid selling assets during a market downturn a reasonable cash reserve should be maintained to meet margin calls. Maintaining a lower LVR may also reduce the risk of a Margin Call.

Geared Unit Trusts
Geared unit trusts operate in a similar manner to ordinary unit trusts however the fund manager will
use the underlying assets as security for borrowing. The trust will gear to a pre-determined level as stipulated in the Product Disclosure Document.

Cautions
With some geared managed funds it is not evident from the fund’s name that it is internally geared. Many hedge funds and property funds are internally geared (or leveraged). Gearing always increases risk so ask your adviser if recommended funds are geared and by how much. If you gear and the fund also gears, you are doubly geared and that may be far too much.

Borrowing on your home to invest in geared funds or a margin lending facility may similarly result in unacceptably high risks. Gearing accelerates both good and bad outcomes; i.e. it speeds up both wealth creation and financial ruin. Gearing must always be used with very great caution.

If you are considering an investment gearing strategy your Lifespan Financial Adviser will be able to assist in ascertaining if a gearing strategy is suitable by taking into account lifestyles issues, your cash flow requirements, taxation issues and your existing asset base.

Pitfalls and Risks

Despite the potentially advantageous effects of
gearing an investment to increase profits and maximise after tax returns, there are several risks associated with gearing, in addition to cautions explained earlier.

Gearing can result in financial losses if the following happens:
The investments selected fail to grow in value yysufficiently to cover interest and other costs.

The investments selected fall in value. Where yythey fall in value sufficiently to wipe out one’s own equity in the new investment, it means one has effectively lost 100% of one’s own capital invested. For example, if you put a $60,000 deposit on a $200,000 property which fell 30% in value, one’s equity would be equal to the loan of $140,000.

If this property was sold, there would be nothing left for the owner after repaying the loan.

The investor is unable to meet interest costs and yymust sell the investment at a time when there is a market downturn. This is one reason why Income Protection Insurance is so important for geared investors, it can help protect against this where the investor suffers a loss of income caused by total or partial disability due to sickness or accident. If a geared investor loses his regular income and is unable to meet repayments or margin calls, then the investor may have to sell the investment at a bad time and suffer a capital loss. Income protection can prevent this from happening by providing security of income.

Disclaimer: The material provided in this document is provided for information only and constitutes general financial product advice. It does not take into account your personal financial situation, objectives and needs. Consequently before acting upon the information in this brochure you should consider its appropriateness to your financial situation, objectives and needs.