A geared investment, is one that has an loan attached to it. Borrowing to invest creates financial leverage, which enables us to gain access to a wide range of investment options which would not be available if we used only our own funds. Gearing can be used with all sorts of investments including shares, managed funds, business, and residential property.
Negative gearing occurs when the costs of holding an investment outweighs any income generated by that investment. This means that as investor, you need to contribute some of your own funds in order to cover interest on loans and other ongoing costs.
Positive gearing occurs when the costs of holding an investment are less than the income generated by that investment. This means that the investment if essentially paying for itself, and the investor does not need to contribute additional funds in order to hold the investment.
The difference between negative and positive gearing, is in the impact the investment has on your income. A positive geared investment generates a net income gain for the investor. A negative geared investment creates a net income loss for the investor. Investors with positive geared investments will pay tax on their additional income. Investors with negative geared investments will be able to claim a tax deduction on the income losses they incurred from holding their investment. The difference is shown in the table below:
In the example above, both investors have an identical investment portfolio in shares worth $40,000. Yet there is a difference of $488.41 in their net cash flows. The difference is in how they have applied their gearing. Mr. Neg, has used used $10,000 of his own funds, and borrowed $30,000 making him negatively geared. Mr Pos has used $20,000 of his own funds and has borrowed $20,000, making him positively geared.
Both investors have the same market exposure, but Mr Neg has to pay in an extra $160.98 per year to cover the interest short fall. Mr. Pos receives an additional $327.43 per year for holding the exact same investments. For simplicity, we have assumed that the dividends earned are inclusive of any franking credits.
If Negative Gearing Is Losing Money, Why Use It?
In our example, Mr Neg, could have adjusted his portfolio so that it was positively geared. It would require him to either contribute a larger deposit, or use a smaller loan. This would mean that the could receive an ongoing income, rather than have to make ongoing payments to maintain his investment.
Mr. Neg, and many Australians like him, are happy to keep their investments negatively geared because they want more exposure to the investment. They believe that over the long term, the leveraged benefits of capital gains, outweigh the cost of negative gearing. This is shown below:
If after one year, the investors from our first example decided to sell their investments for $50,000, then they would've both made a capital gain of $10,000. After CGT, interest and dividends, Mr Neg has a total return of $8,264, while Mr Pos has a total return of $8,752.
Mr. Neg has only used $10,000 of his own funds, so the return on his own deposit is 83%. Mr Pos used $20,000 of his own funds to invest in the same portfolio, and achieved a return on his deposit of 44%.
Mr. Neg has used less of his own funds to generate a similar total return. His ongoing costs were a little higher, but when it came time to sell, his return on investment was almost double that of Mr.Pos. This is because leverage magnifies your gains and losses. Mr Neg achieved a better return, but he also took on more financial risk.
Mr. Neg was willing to take on more risk, in order for the potential to earn greater returns. By doing so he also accepted that there was the potential for greater losses, as shown below:
In the event that our two investors had to sell for a loss after one year, then negative gearing magnifies the losses. Mr. Neg would have lost a total of $8,586, or 86% of his own money, while Mr. Pos would have lost $8,098 or 40% of his own funds.
A Note of Caution
If used responsibly, gearing can help you build a well diversified portfolio. However be careful not to over commit yourself. You don't want to be in a situation where your loan payments are hurting your lifestyle.
If you decide to use a margin loan to invest in either shares or managed funds, then remember that these markets can fluctuate in value, and in the event of a price fall, you might get a margin call. A margin call means you either have to add more funds to your loan or have your holdings sold down. You can reduce the risk of margin calls by borrowing at conservative levels and investing across a well diversified array of investments.