Ever considered using borrowing to fast-track and maximise your wealth?
It can be an extremely successful investment strategy when used wisely and when the investor understands the best processes as well as the potential risks.
Everything that happened in financial markets in 2020 affected the Australian economy significantly. One of the effects is that interest rates are at an all-time low so if you are thinking of going forward with a strategy to borrow money to buy assets (property or shares), now may be an ideal time for you to get started.
First, let’s find out a little more about borrowing to invest and how it works.
What is borrowing to invest?
Put plain and simple, you borrow money to purchase assets that you may not normally be able to afford with just a cash investment.
The goal of borrowing is to increase your investment return by using funds from a lender as well as your own money.
Borrowing money enables you to invest more which may allow you to create more wealth. However, if your chosen investments do not perform as well as expected, this can also increase your losses.
The three types of Borrowing and how they work
Borrowing can be negative, positive or neutral. This refers to the cost of the investment (i.e. interest costs and other investment expenses) in relation to the investment income generated (i.e. dividends and rent).
1. Negative gearing: your investment expenses (including the interest for your loan) is more than the income you will receive from your investment. As the investor, you will need to have extra income sources to make up the shortage.
2. Positive gearing: the investment expenses are less than the income from your investment. This is referred to as a self-funded strategy.
3. Neutral gearing: the costs of the loan are approximately the same as the income generated.
For a Borrowing strategy to be effective, the overall return from your investment should be more than the cost of the loan and other investment-related expense. This can usually be achieved by investing in growth assets such as property and shares.
Many investors negatively gear as they can generally claim a tax deduction on the investment losses. However, this is still costing you money, so it is important to consider how much cash you have coming in from other sources.
The benefits of borrowing to invest may include:
1. Increasing the size of your investment and increasing your return.Interest and other related borrowing costs are usually tax deductible if the loan is used to acquire an income generating asset. The tax benefits of gearing are attractive; however, the purpose of your gearing strategy should be to maximise your finances.
2. Enables you to increase the size of your investment portfolio: this can help to diversify your investments or buy larger assets
As with any opportunity, the greater the potential reward, the greater the risk. Although the benefits of borrowing to invest are attractive, it is vital that you consider the following risks before implementing a gearing strategy:
A rise in interest rates is always a potential. You should ensure you have sufficient cash flow to ensure you can absorb these interest rate increases.
Legislation may change in the future in relation to interest or tax deductibility. You should consider this possibility before investing.
An unforeseen event such as the loss of your job, an illness or injury that may affect your cash flow. This may make it difficult for you to pay back your loan.
Your investment may fall in value. This may cause your originally self-funded strategy to become an investment that is not making you money anymore.
Is borrowing the right option for you?
Borrowing to invest is a long-term strategy. You should make sure you are aware of the risks associated with borrowing before deciding if it is for you.
However, the effects of COVID-19 mean that interest rates are at an all-time low, which means the cost of borrowing is also low. The current economic environment may present the perfect opportunity for you to look into your investment options and consider gearing as an option.