Should you gear your investments?PUBLISHED : | UPDATED:
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Careful, don’t slip ... if you’re drawing funds from a home equity loan to invest you could put your property at risk. Photo: Rob Homer
As interest rates fall and companies produce stable dividends investors may consider boosting their market exposure through investment lending.
The case for
■ Gearing magnifies investment gains. Say you have $25,000 to invest and have identified an asset that you expect to generate a 10 per cent annual return. After one year, the $25,000 investment would have earned you $2500. If you borrowed to invest, at a 50 per cent loan-to-value ratio, for example, you would have boosted your exposure to the asset to $50,000. Then, your profit after a year would be $5000 on your $25,000 plus the $25,000 that you borrowed.
■ You usually have to take on more risk with investments for higher returns. Borrowing to invest lets you increase the amount of risk you’re taking in your portfolio without having to resort to more speculative assets.
■ Borrowing to invest can be tax effective as interest on the loan is tax deductible. If you have a fixed-rate loan, you can pre-pay interest before the end of a financial year, bringing forward the associated tax deduction.
■ With interest rates low, the return you need an investment to produce to make gearing worthwhile has come down. The average rate of interest on a home equity loan was 6.8 per cent in November, according to Reserve Bank of Australia figures. That’s down from 7.9 per cent in mid-2011.
■ There are many ways to borrow to invest. You can take out a full-recourse margin loan or a limited recourse facility that you can use inside a self-managed super fund. Protected loans are available where, at worst, all you stand to lose is the interest you’ve paid on the borrowings. Alternatively, you can put your investments on the house and borrow using the equity in your property as security.
The case against
■ Just as borrowing to invest can magnify returns, it can also magnify losses. If the 10 per cent gain in the example above, turned out to be a 10 per cent loss, you would have dropped $5000 instead of $2500 if you’d just used your own money. On top of that you’d still have to repay the $25,000 debt with interest.
■ Margin calls: two words that strike fear into the heart of many people who have an investment debt. If the value of the investment underlying a margin loan drops below a threshold set by the lender, it will contact the borrower and demand that the investment be topped up with cash or other securities, or that the loan be repaid. Investors are usually given 24 hours to comply before the lender can sell their assets to recover what they’re owed.
■ If you’re drawing funds from a home equity loan to invest you could put your property at risk. There are no margin calls with this type of borrowing, but the lender has recourse to your property if the investment value falls by too much.
■ While the average variable rate for a home mortgage was 6.25 per cent in November, according to the RBA, the average interest rate on a margin loan was 8.55 per cent. An investment would have to return more than that to make it worthwhile to invest using a margin loan.
Si VERDICT: Gearing into an investment adds a layer of complexity. Many investment decisions are complicated enough, without adding the extra dimension of considering what type of loan to use and which provider to buy it from. You also have to monitor the portfolio more closely than if you were using your own money only.
Zoë Fielding Smart Investor