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.