Borrowing to invest, also known as gearing or leverage, is a risky business. While you get bigger returns when markets go up, it leads to larger losses when markets fall. You still have to repay the investment loan and interest, even if your investment falls in value.
Borrowing to invest is a high-risk strategy for experienced investors. If you’re not sure if it’s right for you, speak to us.
How borrowing to invest works
Borrowing to invest is a medium to long term strategy (at least five to ten years). It’s typically done through margin loans for shares or investment property loans. The investment is usually the security for the loan.
A margin loan lets you borrow money to invest in shares, exchange-traded-funds (ETFs) and managed funds.
Margin lenders require you to keep the loan to value ratio (LVR) below an agreed level, usually 70%.
Loan to value ratio = value of your loan / value of your investments
The LVR goes up if your investments fall in value or if your loan gets bigger. If your LVR goes above the agreed level, you’ll get a margin call. You’ll generally have 24 hours to lower the LVR back to the agreed level.
To lower your LVR you can:
Deposit money to reduce your margin loan balance.
Add more shares or managed funds to increase your portfolio value.
Sell part of your portfolio and pay off part of your loan balance.
If you can’t lower your LVR, your margin lender will sell some of your investments to lower your LVR.
Margin loans are a high risk investment. You can lose a lot more than you invest if things go sour. If you don’t fully understand how margin loans work and the risks involved, don’t take one out.
Investment property loans
Investment property loans can be used to invest in land, houses, apartments or commercial property. You earn income through rent, but you have to pay interest and the costs to own the property. These can include council rates, insurance and repairs.
Borrowing to invest is high risk
Borrowing to invest gives you access to more money to invest. This can help increase your returns or allow you to buy bigger investments, such as property. There may also be tax benefits if you’re on a high marginal tax rate, such as tax deductions on interest payments.
But, the more you borrow the more you can lose. The major risks of borrowing to invest are:
Bigger losses — Borrowing to invest increases the amount you’ll lose if your investments falls in value. You need to repay the loan and interest regardless of how your investment goes.
Capital risk — The value of your investment can go down. If you have to sell the investment quickly it may not cover the loan balance.
Investment income risk — The income from an investment may be lower than expected. For example, a renter may move out or a company may not pay a dividend. Make sure you can cover living costs and loan repayments if you don’t get any investment income.
Interest rate risk — If you have a variable rate loan, the interest rate and interest payments can increase. If interest rates went up by 2% or 4%, could you still afford the repayments?
Borrowing to invest only makes sense if the return (after tax) is greater than all the costs of the investment and the loan. If not, you’re taking on a lot of risk for a low or negative return.
Some lenders let you borrow to invest and use your home as security. Do not do this. If the investment turns bad and you can’t keep up with repayments you could lose your home.
Managing the risk of an investment loan
If you borrow to invest, follow our tips to get the right investment loan and protect yourself from large losses.
Shop around for the best investment loan
Don’t just look into the loan your lender or trading platform offers. By shopping around, you could save a lot in interest and fees or find a loan with better features.
Don’t get the maximum loan amount
Borrow less than the maximum amount the lender offers. The more you borrow, the bigger your interest repayments and potential losses.
Pay the interest
Making interest repayments will prevent your loan and interest payments getting bigger each month.
Have cash set aside
Have an emergency fund or cash you can quickly access. You don’t want to have to sell your investments if you need cash quickly.
Diversify your investments
Diversification will help to protect you if a single company or investment falls in value.
Gearing and tax
Borrowing to invest is also known as ‘gearing’. Before you borrow to invest, check:
if you will be positively or negatively geared, and
how this will impact your cash flow and tax
Kyle gets a margin call.
Kyle has $10,000 invested in shares. He decides to borrow $15,000 to invest in more shares through a margin loan. The total value of his shares is now $25,000.
Kyle’s LVR is 60% ($15,000 / $25,000). The maximum LVR his margin lender allows is 70%.
Kyle has invested in five mining companies. He’s taking on a lot of risk as he’s not diversified. After a fall in the price of commodities, Kyle’s shares fell by $5,000. The total value of his investments is now $20,000. The value of his investment loan is still $15,000.
Kyle received a margin call from his lender as his LVR had increased to 75% ($15,000 / $20,000). He had 24 hours to lower his LVR.
Kyle used $2,000 of his savings to reduce his loan balance to $13,000. This lowered his LVR to 65% ($13,000 / $20,000).
Kyle has money in a savings account ready in case he gets another margin call.
Please contact us to find out more about this topic.
Reproduced with the permission of ASIC’s MoneySmart Team. This article was originally published at https://moneysmart.gov.au/how-to-invest/borrowing-to-invest
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