Borrowing money to invest in shares is commonly referred to as ‘gearing’. Read on for a short guide to gearing, the pros and cons of borrowing to invest, and where you can find more information on borrowing to invest in shares.
What is gearing?
Investing in the stock market can be a great way to make money, period. However, not everyone has the capital they need to get started straight away, so more and more people are borrowing money from lenders to invest. Gearing has the potential to increase profits with your money as you have more to invest with, but it can also increase losses.
The other type of gearing (with the aforementioned gearing being positive gearing) is negative gearing, which occurs when you borrow to invest in an income producing asset but the cost of borrowing is greater than the returns you receive from this particular asset. On a property, for example, negative gearing takes place if the interest you need to pay on the loan is bigger than the rental income you get from the property once other things such as maintenance are figured in.
Advantages of gearing: increasing profits
There are two oft-cited principal advantages of borrowing to invest:
- Increasing your profits – if the shares you buy with the money you borrow increase in value, you win when you sell on the shares. There is also the potential for dividends and bonus shares made by the company in question.
- Tax benefits of negative gearing – If the money you are making on your investment is working out to be less than the cost of borrowing in the first place, you are eligible for a tax deduction on the difference between the amounts.
What are the risks of gearing? Interest rates, financial loss and fees
- The market changes a lot – conditions may change, and rising interest rates may mean you struggle to meet loan repayments, especially if you over-extend benefits.
- You may rely on the income the investment produces, before experiencing a period where there is no income.
- Your loss can be multiplied.
- There may be fees or penalties if paying the loan off earlier than planned.
- Assets simply may not provide the returns you hoped for.
- You may have to pay a ‘margin call’ if the value of your investment falls below the level that covers the lender’s loan.
In short, a bad investment means little or no returns and a big debt that needs paying off too, so good financial advice is crucial.