GEARING is a technical term that conjures up bland images of balance sheets and financial statements or, if you like sports, that bit on a bike that increases or decreases the pain of cycling uphill. A more people-friendly term is borrowing to invest.
Gearing has been criticised heavily this year as the share market suffered its worst downturn in two decades.
People who aggressively took out margin loans - where they buy more shares using their existing shares as security - have had their investments sold from under them. Others have been stung by the collapse of fringe stockbrokers such as Opes Prime.
Despite all the negative noise, borrowing to invest remains one of the most popular growth strategies for both businesses and serious investors.
"Most wealthy people build their wealth to some extent assisted by other people's money,'' said Barker Wealth Management managing director Peggy Barker.
"But you have to be careful with the timing and affordability from a cash-flow point of view and, of course, the quality of the investment that you are going to put your money into.''
Financial experts say property and shares have been the two biggest destinations for investors using borrowed money, because both have averaged annual returns above 10 per cent over the long term.
A loan for an investment property is easiest to understand because many people already have a mortgage. Borrowers are able to use existing equity in their own home as the deposit and security for the investment loan.
Borrowing to own shares is more complex - and frightening for many - because of the volatility of the share market, the huge range of companies to choose from and different ways to borrow. But the overall message is the same: Choose quality assets.
For shareholders, that means focusing on blue-chip companies rather than speculative stocks that can gain or lose half their value in just a few weeks.
Goldsborough Financial Services adviser Brenton Miegel said debt investments were not for conservative investors and those who did not want too much volatility in their portfolio. ``Gearing suits a more aggressive investor who is prepared to take a greater degree of risk and accept greater volatility,'' he said.
"Gearing will magnify the possible gains, as well as the losses - as many will have seen in the past 12 months.''
Mr Miegel said the biggest pitfall was overcommitting: ``Borrowing too much, being too aggressive and then not being able to fund or finance the debt. Starting small, and gradually building an investment portfolio, and a commensurate level of debt, is a good way to avoid this.''
William Buck financial services adviser Simon Rees said gearing had the potential to increase returns and could also provide tax benefits as the costs of investing - such as interest repayments - were generally deductable.
"However, borrowing can magnify your losses when markets decline,'' he said. ``Additionally, if you have a margin loan, you may also need to meet a margin call where you either contribute more cash or be forced to sell down assets. In the worst case, you could lose all of your investment and still have the loan which needs to be repaid.
"Interest rates may also rise and you could have to pay more interest than you anticipated. If your investment is negatively geared, you will have to fund the cash shortfall from other sources, such as your salary.''
Using equity in your home is usually seen as the best option for investment loans. First, there is no risk of a margin call on shares or managed funds.
As long as you make the repayments, the lender does not care how much the asset has fallen or even if the portfolio is worth less than the amount owed.
Second, interest rates on home equity loans are much lower - at least 1 per cent - than other forms of finance, such as margin loans.
Mrs Barker said margin calls were the biggest pitfall with margin loans.
"The problem with them is at the very worst time, when your assets are down, you are asked to find assets to top up your loan,'' she said.
Investors could reduce the risk of a margin call by not borrowing the maximum amount allowed, usually 70-75 per cent of the overall portfolio.
"If you are 50 per cent or less geared, you are relatively safe. We never recommend more than 50 per cent geared,'' Mrs Barker said.
Mr Rees said for someone who borrowed 50 per cent of the portfolio to buy shares with a long-to-value ratio of 70 per cent, the portfolio would have to fall by about 37 per cent before a margin call was made.
"To minimise the risks when borrowing, we suggest to gear conservatively, invest for the long term, diversify your investments, reinvest income and either prepay interest or pay interest regularly,'' he said.
"Additionally, we recommend that our clients take out income protection insurance and additional life insurance when using gearing strategies.''
Mr Miegel said while there were immediate tax benefits, the biggest benefit of borrowing to invest was building a solid investment portfolio over the long term. Fellow Goldsborough adviser Sam Martin said a long-term focus was crucial.
"Borrowing to invest often suits higher-income earners as the interest costs are tax-deductable, providing bigger tax savings to investors in the higher tax brackets,'' he said.
For example, someone on the top tax rate of 45 per cent would get 45 per cent of their interest costs back at tax time, while those on a 15 per cent tax rate would get just 15 per cent back.
"Other than taxation benefits, borrowing allows people to take advantage of investments when they normally could not afford to purchase a particular asset,'' Mr Martin said.
"The biggest pitfall can be when people borrow to invest and intend for the asset to provide the income to meet the interest costs of the loan,'' he said.
"It is always preferable that borrowing costs are met with other regular sources of income so that if the investment doesn't perform in the short term, the assets do not have to be sold off to pay the debt. It is always best to have control of when the investment is sold.
Typically, it does not suit people who aim to invest for the short term, people in the lower tax brackets or people without reliable cash flow.''
