Borrowing to invest
by Wealth Know How in DIY Investing
You can invest in the share market by borrowing money to buy more shares than you might afford. To many this might sound terrifying and they should avoid it but it’s really much the same concept as borrowing to buy a house. Learn what ‘gearing’ means and how both profits and losses are magnified.
- sponsor - Wealth Know How
Wealth Know How is the online network helping people manage their wealth through financial education. Whether you are looking for simple ways to better manage your cash, or you are after a complete strategy on how to save for retirement, we can help you understand your options. It is important to have a vision for your future, but its knowledge not dreams that will ultimately deliver financial success.
Published on 25 Jul 14
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You can invest in the share market by borrowing money to buy more shares than you might afford. To many this might sound terrifying and they should avoid it but it’s really much the same concept as borrowing to buy a house. Learn what ‘gearing’ means and how both profits and losses are magnified.
Sponsor - Wealth Know How
Wealth Know How is the online network helping people manage their wealth through financial education. Whether you are looking for simple ways to better manage your cash, or you are after a complete strategy on how to save for retirement, we can help you understand your options. It is important to have a vision for your future, but its knowledge not dreams that will ultimately deliver financial success.
-
Venezuela tension heats up
Duration 03:16
-
Aussie dollar surprises market
Duration 03:10
-
Markets climb as investors watch US healthcare bill
Duration 02:31
Borrowing to invest is called 'gearing'. Because your investment is geared, both profits and losses are magnified. The high returns can seem fantastic when markets are rising but the losses can be huge when the market falls – which makes gearing into shares a potentially very risky business, and only suitable for experienced investors.
When you borrow, the shares are used as security on the loan. You own the shares and are fully entitled to all dividends and bonuses. But just as with a home loan, you’ll have a loan-to-value ratio, and a ‘margin’, which is the value of your capital in the loan. If the shares fall in value, you may be asked to sell some shares or deposit more cash to bring the margin back to an acceptable level. This is known as a margin call and protects the lender if your investment drops in value.
If the value of the shares increases, your equity in the portfolio rises. That’s the good side of leveraged investment. On the other hand, a decrease in the value of the portfolio magnifies the fall in your equity. If you can’t meet a margin call, the lender will sell the shares and you may still owe the lender money.
However, the more conservative you are on your initial loan-to-value ratio, the higher-quality are the shares you buy, and the more diversified your portfolio is, the likelihood of a margin call lessens considerably, and the loan works to build wealth in exactly the same manner as a home with a loan.
And because a share loan is for the purpose of earning assessable – or taxable - income, the ongoing borrowing costs, such as interest and fees, can be tax-deductible. As always, however, any tax benefits alone are not a good enough reason to gear an investment. To profit before or after tax the investment still needs to perform better than the cost of interest on the loan.
A share investment loan requires a lot of thought about the possibility of losing money. Maybe the best approach is to get some professional financial advice to make sure the strategy is suitable for your needs.