There are several types of gearing available. All of them involve a loan in some form or another, but it may not be a loan that you are directly involved in. Gearing is a term which means borrowing to invest. Gearing allows people to be able to buy investments without having to come up with the full amount.
There are three different types of gearing and they are an investment loan secured by property, margin loan secured by the share investments and investments with built in gearing. These types of gearing are explained below.
Investment Loan Secured by Property
In many cases, an investor already has a property in which they have built up equity. By increasing the loan on this property as a separate portion, borrowers are able to use the equity to fund the planned investment or the deposit. If the investment is another residential property, then the equity release can be a way of coming up with the deposit and costs like stamp duty. A separate loan is then taken out against the property being purchased, ideally at 80% lend or less to avoid mortgage insurance.
Loans secured by residential homes have the lowest interest rate, no margin calls, no list of approved investments. The funds can be used to purchase an investment property above or could be used to purchase shares or managed funds.
To ensure that the equity released is tax deductible ensure that it is separated from your other debt. Only use money that is withdrawn from this loan portion for paying for things relating to your investment. If you decide to take out some money to use for personal use, the debt is corrupted and you may not be eligible for tax deductions
. Always seek the advice of a qualified accountant.
Margin Loan Secured by the Investment
Applying for a margin loan and a home loan are very similar. Your income and expenses are evaluated as well as your assets and liabilities. Although your house and home loan are considered an asset and liability, the margin loan isn’t connected to these.
After you are approved for a margin loan, you will be given a certain amount of credit and a list of suitable investments which may include direct shares and managed funds. Each of these will have gearing ratios specified. You will need to put some money towards any investment purchases in order to keep the lending ratio at or below the maximum.
It is important to be aware of what a margin call is. If the values of your share investments decrease, then the lender can notify you to bring your lending ratio back to what you initially agreed. If this happens then you will be required to either contribute more of your own funds or to sell some of your shares to bring it back to an acceptable borrowing level. Your provider has this margin call to ensure that there is enough value in the share investment to repay what owes on the loan. This can be particularly stressful if the share market is particularly volatile or there is a sharp decline.
Investments with Built in Gearing
There are a few different examples of investments where gearing is actually a part of the investment itself.
Geared Managed Funds
The investment managers for managed funds deal with the money that comes in and invest it according to the guidelines. For geared investments they would have guidelines that for every dollar invested they can borrow a certain percentage. Typically it is geared in such a way that dividends from the shares will cover the interest to be paid on the loan.
This type of investment is buying shares with progress payments. Simply put, you pay upfront for part of the share and then make repayments over a period of time until you own the whole share. The benefit of this investment is that you get the full benefit of owning the share straight away, even if you have not paid for the whole share.
Each of these types of gearing has the potential to provide a profitable investment for you. But just like any investment, there are risks involved. Always seek the advice of a qualified accountant or financial planner when considering different investment options involving gearing.