What is gearing and can it work for you?

Gearing (also known as 'borrowing to invest' and 'leveraging') is the strategy of using borrowed money to purchase extra investments.

Borrowing to invest may not be a suitable strategy for you. While gearing has the potential to magnify gains, it will always magnify losses suffered if the value of your investments falls. You may have to cope with potentially large fluctuations both up and down in the value of your investments. Depending on the type or nature of the gearing strategy there may be other consequences which should be fully understood with professional help before you take up any gearing strategy.

Although it can lower your tax liability, the tax implications will depend on your personal situation and the type of investments you choose. Geared investments generally involve much higher risk than non geared investments and you should seek financial advice before borrowing money to invest.

The main benefit is that your investment balance is bigger. This means the potential dollar returns could also be bigger. But borrowing to invest is only worthwhile if your returns are greater than the interest you pay on the borrowings.

Another reason to 'gear' an investment is that the cost of investing (including interest) may be tax deductible. Naturally, this depends on your personal situation and the type of gearing strategy you chose so its always wise to seek professional help.

Benefits Risks
If your investments increase in value, gearing can magnify gains If your investments go down in value gearing will magnify losses
It increases the amount you have to invest In the worst case, investors may lose their total investment, and depending on the type of gearing strategy may still have the loan remaining, which needs to be repaid and serviced (see below for more details)
May reduce tax as the costs of investing are generally deductible There may be interest penalties if the loan is repaid sooner than agreed
You can achieve higher returns (after costs) than without gearing Returns must be higher than the interest costs for gearing to be of benefit.
Internally geared funds borrow at institutional rates Unit prices for geared funds are more volatile than similar ungeared funds

There are broadly two different ways you can borrow to invest
1. Geared share funds
Geared share funds are 'internally' geared. Basically, the fund manager uses the fund’s assets to support the borrowing and the investor's liability and loss is limited to the amount they invest. As such, in the worst case, you may lose your total investment, however there is no requirement for you to service or repay any residual loan.

2. Home Equity Gearing
If you are a homeowner you may be able to borrow against the equity in your home and then use the money to buy investments. The equity in your home is used as security for the loan, not the investments. In the worst case, you may lose the total investment and still have the loan remaining which needs to be repaid and serviced. If you do not comply with your loan requirements the lender could take recovery action against you. In a worst case this may involve, selling your home to repay the loan.

Gearing Method Comparison:
The below table outlines some of the main differences between gearing options:

  Geared Funds Home Equity
Further recourse to client No Yes
Responsibility for margin call Not applicable Investor
Gross up franking credits Yes Yes
Potential for deductibility of interest Yes, via fund Yes
Ability to pre-pay interest Generally no Yes
Interest rates Institutional Retail
Ability to set the Gearing Ratio The Fund Investor/lender
Superannuation funds potential to invest or use gearing Yes Generally not available
Credit checks and other loan-specific checks No Yes
Paperwork The Fund Investor

What does Colonial First State have to offer?
Colonial First State FirstChoice has a choice of geared share funds. You can invest both super and non-super money into these geared funds with as little as $1,000.

Australian share geared funds

  1. Colonial First State Geared Australian Share – Core
  2. Colonial First State Geared Share
  3. FirstChoice Geared Boutique Australian Share

Global share geared funds

  1. Colonial First State Colliers Geared Global Property Securities
  2. Colonial First State Geared Global Share
  3. Acadian Geared Global Equity

Multi-Sector geared funds

  1. FirstChoice Geared Growth Plus

What to consider next:

Speak to your financial adviser or choose an option here:

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The information contained in this document is based on the understanding Colonial First State Investments Limited ABN 98 002 348 352 AFS Licence 232468 has of the relevant Australian laws as at 1 July 2009. This document is not advice and is intended to provide general information only. It does not take into account your individual needs, objectives or personal circumstances. You should assess whether the information is appropriate for you and consider talking to a financial adviser before making an investment decision. Product Disclosure Statements (PDS) for products offered by Colonial First State are available from colonialfirststate.com.au or by contacting us on 13 13 36. You should read the relevant PDS and consider whether the product is right for you. Past performance and awards are no indication of future performance.