With interest rates on a downward trajectory to all-time lows, getting a decent return on money invested in the bank or on fixed income has never been tougher.
But with Reserve Bank rate cuts reducing the cost of borrowing, it’s an opportune time to consider gearing – putting borrowed money to work to make more money – into property, shares or managed funds.
But to ensure that borrowing cheap money isn’t the worst decision you’ll ever make, you need to explore some options and whether they’re right for you.
First the tough love: Gearing is, by its nature, a risky business. If the value of the investment nosedives, a geared investment will suffer a greater loss than an investment that is not encumbered by a loan.
For example, if an investment value falls by 20 per cent, an unencumbered $10,000 will reduce to $8000. However, factor in the nasty impact of leverage, and a geared $20,000 will decline to $16,000, reducing the original $10,000 to $6000 less the borrowing cost.
Still like the idea of gearing, but have no appetite for the risks associated with margin calls that come with borrowing from a bank or broker?
Why not consider a handful of financial providers that have built their entire fund around a lower-risk strategy?
Sometimes referred to as a ‘one-click’ gearing strategy, due to its built-in loan facility, internally geared share funds offer a no-fuss way to reap the benefits of gearing, without the downside risk if things go pear-shaped.
That’s because they’re what’s called ‘limited-recourse’ loans which, unlike margin loans, means if the investments fall in value below the level of fund borrowings, you’re not the bunny who ends up paying back the shortfall.
One of the pioneering funds in this space is the Colonial First State geared Australian fund.
Since the early 2000s there are many similarly geared share funds on offer, including the Perpetual wholesale geared Australian share fund.
In a similar vein, ETF providers like BetaShares offers a geared Australian equity fund ETF (ASX: GEAR) based on the performance of the S&P/ASX200.
Another strategy also worth considering is what’s called instalment gearing.
This is when people who don’t have large sums of money – yet still like the idea of accumulating shares or units over time – can invest small, equal amounts at predetermined intervals in shares or managed fund units, or you can micro-invest into shares or residential property $100 (or less) at time.
This strategy can be done less regularly, or through what’s called dollar-cost-averaging (DCA).
Relax, it’s just a fancy term for a regular savings plan that allows you to progressively grow a share or unit portfolio that will return significantly more than debt instruments (aka fixed income like term deposits), like cash.
The beauty of a DCA strategy is that it eases your entry into shares or units through regular purchases.
As a result, you’ll end up with an average buying price that’s lower than the average price over the same timeframe.
You can either choose to use your own funds or what’s often referred to as debt recycling, which is simply using a low-interest offset account on your home loan.
Given that they can be seriously bad for your financial health, Commonwealth Bank of Australia senior economist Gareth Aird isn’t surprised to see a direct link between the greater use of mortgage offset accounts, and the declining use of personal credit (including credit cards) and marginal loans.
For most people debt-recycling is a no-brainer, as it avoids the risks associated with a $200,000 margin loan that could be called in at any time.
However, Omniwealth senior financial planner Andrew Zbik reminds people that the interest on this debt technically isn’t tax-deductible if it’s being used for any purpose beyond which the loan was originally taken.
“Pulling cash out of any offset to buy debt is the first mistake people make, because it isn’t tax-deductible,” Mr Zbik said. “But that doesn’t mean the offset isn’t useful.”
Debt recycling works best, he adds, when people have the money in their offset refinanced into a new loan (albeit at a slightly higher rate) to buy shares in a tax-deductible manner.
Even though you may not wish to buy shares right now, Mr Zbik says by having your offset refinanced, you’ll be properly structured to capitalise on market opportunities when they arise.
Three reasons why mortgage debt beats margin debt
- Marginal-debt interest rates are usually meaningfully higher than mortgage debt, and you’ll need a considerably higher return to cover the cost
- Given that they’re secured against a house, mortgage loans aren’t ‘called’, whereas bank/brokers can and do “call” loans. You may need to top it up with new cash if your equity falls and you may be forced to sell if you can’t refinance
- Share prices are typically more volatile than house prices, which means if someone had a margin loan during the GFC that equated to 70 per cent of a $1 million portfolio, a 50 per cent fall would have seen the bank sell all of their shares, at or near the bottom of the market – leaving them with absolutely nothing left.