Gearing simply means borrowing money to buy an investment asset. Essentially, you have taken out a loan to purchase an income producing investment or asset. Many people are familiar with gearing a property investment, but the same process can also apply to shares.
- Negative gearing means that the interest & other expenses that you are paying on the loan is more than the income. As a result you are making a loss.
- Neutral gearing means that the interest & other expenses that you are paying on the loan is equal to the income.
- Positive gearing means that the interest & other expenses that you are paying on the loan is less than the income. As a result you are making an annual profit.
So, if negative gearing means that you’re making a loss, why is that a positive? Obviously nobody wants to get into an investment to lose money. Even though most investments that you will buy will be negatively geared, that is the income is not as much as the interest repayment and combined total of expenses necessary to maintain the investment, the benefit comes from the capital growth. So the intention is that the appreciating asset will grow at a rate greater than the annual loss, thereby putting the investor in profit territory.
It would be great to be neutrally or even positively geared and still make a net profit but these sorts of investments are very hard to find. However, neutrally or positively geared investments can be acquired if the purchase of the investment is not funded from 100% of the borrowed funds. This approach is a genuine risk mitigating strategy, for geared investments. We call this improving the debt equity ratio.
So negative gearing can provide genuine benefits to an investor, by magnifying the underlying return from the investment. But this magnification works both ways, if the investment was to perform poorly and provide negative returns then these poor returns are also magnified for the investor in a negative sense.
So it’s not for the faint hearted and should only be used as a wealth creation strategy under the right circumstances and set up in the correct fashion. We have been helping clients with gearing strategies (or as it’s otherwise known, Leveraging) for many years. We can handle both the debt set up arrangements and the investment acquisition for the client, keeping the clients involvement restricted to simply ensuring that they are fully informed on how it all works and the risks associated.
