With gearing, you borrow money to invest. As mentioned before, it is best to pay off all your debts before looking into any investment. However, there will be situations when the investment is good and it is necessary to borrow a small amount for the business to work. Borrowing can be for real estate or stocks.
Gearing allows you to increase your investment and potentially get a higher return. On the other hand, if the investment doesn’t pay off, you risk losing a lot more. A negative debt ratio occurs when the interest you pay on your borrowing is greater than the income from your investment (such as a rental property). You can claim the loss or difference for tax purposes and deduct it from other income.
Negative gearing is not necessarily the best investment strategy. Even if you get a tax break, it still costs you money. That means you might save 25 cents on the dollar, but you have to spend a dollar to get there.
People look at negative gearing because they assume they can sell the investment for more than they bought it and, in the meantime, offset their losses against other income they earn. They conclude that the Commissioner of Inland Revenue is actually helping them finance the appreciation of their property.
If it can be avoided, don’t borrow your home for investment. This is especially true if the investment is speculative. Things are going wrong and you don’t want to find yourself (and your family) out on the streets with no roof over your heads.
Borrowing money to invest is called margin lending. The additional funds raised allow you to invest more and increase potential returns compared to what you would earn with your normal savings. It allows you to use other people’s money, so with a small deposit you can get a significant increase in your wealth.
The downside is when stock prices fall below a level and a margin call occurs. If so, you have 24 hours to respond in one of three ways. You need to raise the money, sell assets, or provide additional assets to increase equity.
If you have a margin loan, make sure you fully understand the terms of your loan and also employ survival strategies in case things don’t work out.