Most people will borrow money at some stage to buy something - a car, a house or even to invest. While media commentators focus on Australians' growing debt levels, they often ignore the difference between "good debt" and "bad debt".
Good debt is generally considered to be tax-deductible debt that is used to invest in things such as property or shares, to generate income. Depending on your financial situation, this type of debt can be tax effective and can help to build wealth and generate income.
Bad debt is not tax effective, does not generate income or wealth, and is more commonly related to lifestyle purchases using credit cards and personal loans.
What is gearing?
Gearing is another term for borrowing money to invest. Gearing allows you to invest in more shares or property than you could otherwise afford if you paid in full with your own money.
Gearing can be used to help build your wealth, but doesn't suit everyone. To decide whether gearing is appropriate for you, consider these things:
- Your return may be increased by using borrowed money to invest more in a rising market, but you may lose a lot more if the market falls.
- You may be able to deduct interest expenses for tax purposes, depending on your circumstances. If you invest in Australian shares, the income generated by the investment may also have tax credits (franking credits) that you can use to reduce your tax bill.
- With more funds available to invest, you can spread your investments across more asset classes which can help to reduce your risk.
Who is best suited to gearing?
Gearing can be appropriate for long-term investors who wish to see greater market gains. Some forms of gearing require interest payments on the loan, so you may need access to surplus cash. Investors who have equity in their home also may like to consider gearing as a way to use that equity to diversify their investments.
Types of gearing
The three most commonly used methods of gearing are:
- home equity loan - If you have equity in your home, you may be able to use your home as security for a loan that you can use to invest in other assets. This type of investing often has an attractive interest rate, though you should remember there are fees and charges associated with property valuations. Also remember that if the market falls significantly, your home may be at risk.
- personal loan - This form of borrowing is usually unsecured and may attract a higher interest rate. It may be suitable for investors who don't have much excess cash, but who can meet regular principal and interest repayments.
- margin loan - Margin lending enables investors to borrow money to invest in shares and/or managed funds, using their existing investment portfolio or cash as security. It is similar to borrowing to invest in property, where the property is used as security. Gearing in the share market can be a flexible, tax-effective investment. Visit the ANZ Investment Lending website for a more detailed explanation of how margin lending works and its benefits.
All forms of gearing carry risk so you should seek professional advice to determine whether gearing is right for you. To work out which form of gearing is best for you, you need to consider:
- whether you can afford to meet repayments, if required, now and in the future
- whether you would like the flexibility to start out small and have your loan grow with your investment portfolio
- what you want to invest in
- whether the ability to closely track your investment and loan is important to you
- whether you wish to invest for the long term.
You need Adobe Reader to view PDF files. You can download Adobe Reader free of charge.