Borrowing to invest in shares
Borrowing money to invest in shares is generally called 'gearing'.
It is an old but true saying that gearing increases the potential profits in your investment because you have more money to invest, but this also means it can increase your losses.
Potential advantages of gearing
There are two advantages of gearing.
You can increase the potential profits
If you borrow $100,000 to invest in shares, and they increase in value, then you get the benefit of that capital gain when you sell the shares. Equally, you get the benefit of any dividends and bonus share issues that may be made by the company while you own the shares.
Negative gearing tax benefit
Negative gearing is when your income from the investment (ie the dividends and bonus share issues) is less than the cost of the investment (ie interest that you are paying to your lending institution on the loan). The difference between the two amounts is usually a deduction on your taxable income.
Rules for gearing into the stock market
Here are some rules to keep in mind when thinking about gearing into the stock market.
- Don't ever fully gear into a stock market investment
- Negative gearing is not for everyone
Rule 1: Don't ever fully gear into a stock market investment
Reputable advisers recommend you keep some money in reserve and avoid borrowing every last cent you possibly could. Interest rates could rise, share markets could fall, and your personal circumstances can change suddenly.
Some people borrow money to invest by using 'margin loans' from a stockbroking firm or some other lender. Lenders let you borrow up to a certain percentage of the current market value of the shares you may be interested in, usually about 70% of the value.
You must ensure the lender is covered at all times for the amount of money you borrowed. If your shares drop in price you will receive a margin call. A margin call happens when the price of the shares falls below a level that would cover the lender's loan to you.
| Example: Suppose you buy shares in XYZ Ltd at $10 per share using a margin loan. Your loan says that you may borrow up to a maximum of 70% of XYZ Ltd's current market value. You borrow the maximum of $7 per share and put in $3 per share of your own money. Two days later, XYZ Ltd falls to $9. Since 70% of $9 is only $6.30, you must cover the lender for the 70 cents per share difference between $6.30 and the $7 you owe. |
This margin call ensures that the lender's level of exposure in dollar terms remains the same. If you fail to pay the margin call, your shares will be forfeited to the lender, who will sell them to recover their money. When you remember that the lender may be selling the shares into a falling market, you can understand why your personal loss can be significant.
Rule 2: Negative gearing is not for everyone
Gearing is a strategy best suited to you if you:
- have enough income from other sources, like a secure salary, or have a reserve of funds to meet possible margin calls if there is a significant drop in the market
- are in the highest income tax bracket, where the tax deductibility of the interest payments is maximised so the actual cost of the borrowed money is reduced as much as possible
- are an experienced investor, having a practical appreciation of the volatility of your investments and the risks involved.
You should not negatively gear into shares unless you are fully satisfied you can meet the interest payments and possible margin calls if the investment turns sour for a couple of years.
More information
More information on borrowing to invest, including negative gearing
If you want to know more about choosing the right financial adviser, read our booklet Getting advice.
More about investing in shares
FIDO Website: Printed 07/29/2010
