To Gear or Not to Gear
That is the Question
Gearing can be an effective strategy to accelerate the process of wealth creation, allowing an investor to make a larger investment than would otherwise be possible for them. But what does it mean to gear an investment and is it the right choice for you?
In simplistic terms when we decide to GEAR an investment we are electing to:
“Invest $X amount per annum (from my ongoing spare cash flow) so that I can borrow monies and have $Y (amount of capital invested) working for me rather than invest the same amount (after-tax dollars) of $X but only have that $X working for me”
So, we can borrow to invest in Growth Assets such as investment property or share-based investments.
Again simplistically the annual cash flow might look something like the following:
For the purpose of this illustration, we have used realistic assumptions of income (as shown) and a long term loan interest rate averaging 6.00% per annum (even though rates are low at present and certainly not sustainable) plus a marginal tax rate of 34.50%.
So for these 2 examples, you could have $600,000 (property) or $100,000 (shares) respectively working for you for your $7,860 or $1,310. OR with no borrowing, you would just be investing $7,860 or $1,310 respectively and have that amount only working for you. We could compare apples with apples and gear $600,000 in shares but I am not sure there would be too many of us willing to do that hence the $100,000 illustration.
Wealth creation can therefore be better or worse with borrowings but it can be very lucrative if good capital growth of the investment occurs over time.
As per usual living with volatility is a bi-product of this strategy. There is a fair bit more in the mechanics, risk understanding and likely outcomes but the above keeps the CONCEPT simple.
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