Debt Management and Leverage
Gearing into investments
First gearing example
Let’s assume you borrow $100,000 at 7.5% p.a. for one year and invest the $100,000 in the share market.
- Your investment is 100% geared (meaning you have put none of your own capital into the investment).
- If the share market goes down by 10% (which is $10,000 on the $100,000 you invested), you have lost $10,000 worth of investment capital as well as 7.5% ($7,500) in interest, therefore a total loss of $17,500 (ignoring tax deductions on the interest).
- This is a large loss as you still need to repay the full $100,000.
- If the share market goes up by 14% (which is $14,000 on the $100,000 you invested), your net return would be 14% ($14,000) less 7.5% ($7,500) in interest, which is a 6.5% gain ($6,500) – ignoring taxes.
Therefore you have made $6,500 on money that was not yours. This second scenario shows the potential benefit of gearing. You do need to carefully consider the downside as well as the upside.
Page 25 of 46