How does gearing work?
If you want to understand how does gearing work, then keep reading, because you can use it to jump start your nest egg.
‘Used wisely, gearing can turbo-charge your return on an investment.’
Borrowing to invest – also known as gearing
– is a way of using other people’s money to get ahead. Used wisely, it can turbo-charge returns on an investment. Gearing works very simply.
Gearing is generally a medium to long-term strategy of at least five to 10 years. But even modest amounts invested can generate real wealth given enough time and dedication to this method. Most of us are familiar with borrowing to make our biggest investment – our own home. So gearing works by simply applying similar principles when borrowing to invest in assets such as a share portfolio, or property.
Gearing can deliver a sound strategy to jump starting your nest-egg because it offers a way to increase the value of your total pool of investments by allowing you to put down a small deposit and borrow the rest. The key is to make sure the total return (income and growth) is greater than the cost of borrowing.
How gearing works
You provide either cash for a deposit, or other assets as security, and receive a loan to fund an investment. The main difference with this type of borrowing is that the loan is used for income-producing purposes. Buying a home that produces rental income, or buying shares that pay dividends are both examples.
When borrowing to invest, you need to consider different types of gearing. Negative gearing is where income from an investment (such as dividends or rental) is less than your interest and/or other expenses. Positive gearing is where income from an investment is higher than your interest and/or other expenses.
People hold a negatively geared asset for two main reasons. First, in Australia, you can typically offset any loss made on one investment, against other income, resulting in tax savings (which works well for those on high marginal tax rates). Second, the capital growth of the assets mean you can sell an asset for a capital gain that more than covers losses over the time the investment was held.
Is gearing right for you?
If you are still wondering how gearing works, depending on your circumstances, the benefits of gearing can include:
- If the investment is positively geared, you have access to a passive income stream (extra money in your budget) that can provide greater lifestyle choices.
- By borrowing to invest, the capital growth potential of your assets is greater. This is because of the greater capital base to begin with. You can use gearing within a self-managed super fund — as long as it complies with ATO rules.
It can be a great strategy if you have a long time frame because the more time your money has to earn, the more opportunity for compounding (adding any earnings received to the amount you contribute [principal] and then reinvesting them to create more potential earnings).
It is easy to see why gearing or borrowing to invest can provide a great approach to building wealth. Every year put off investing makes our ultimate retirement goals more difficult to achieve.
Investopedia provide a handy definition of gearing too.
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