Many people borrow to invest – this is called ‘gearing’. If you are borrowing to invest, it’s important that your investment strategy aligns with your financial objectives. As with any major financial decision, you should be aware of the potential impact on your finances and do some research so you are comfortable with your choice.
Remember that the more you borrow, the more you will pay in interest. If you have borrowed to invest and you’re making a profit, you are positively geared. If you’re making a loss, you are negatively geared.
Either way, gearing will cost you money.
Negative gearing is where you borrow money to invest and the income from the investment is less than the expenses. This is common for property investments, where rental income is less than the interest and other expenses. Essentially this means you’re making a loss.
If you borrow money to invest in shares your investment will be negatively geared if the dividends from the shares are less than the interest on the loan.
You may be prepared to accept a loss if you expect to be able to offset your losses with a capital gain in the future, when the value of the investment increases. An investment loss will reduce your taxable income, and reduce the amount of tax you pay.
Negative gearing can be a popular strategy to minimise tax, but remember that you can only reduce your tax if you reduce your overall income. Investors may focus on the tax benefits of negative gearing without considering the loss in after tax income.
While lower tax can help your savings grow faster, you should never base an investment decision on tax benefits alone. Make sure you take the time to consider your investment goals and choose investments that align with your objectives.
Positive gearing is where you borrow money to invest and the income from your investment is higher than your interest and other expenses. This means you will have extra money in your budget but you will have to pay tax on the additional net income.
Positively geared investments provide ongoing income and a capital gain if the investment has increased in value when you sell it.
If needed, you should seek professional advice on the tax implications of negative and positive gearing, as the more you borrow, the more you will pay in interest.
For more information on smart investing visit ASIC’s MoneySmart website at moneysmart.gov.au.
Greg Medcraft is Chairman of Australian Securities and Investments Commission