Many people find borrowing money a feasible option for when they want to invest. While investing borrowed money, or the so-called gearing, can be a big win for some, it may not be the same for some others. Borrowing money to invest involves a number of risks. If you’re wondering whether or not this is the best decision to make, this article is for you.
Gearing refers to the act of taking out a loan so the money can be used for investment. It generally has both advantages and disadvantages but it all boils down to how your return of investment fares against the amount of money you borrowed. The rest of the article will explain what you need to know to help you decide if gearing is right for you.
What are the benefits of gearing or borrowing to invest?
From the term borrowing to invest, this option provides you the financial resources you need to afford an investment, whether it is a property, business and so on. Taking out a loan for investment may also allow you to enjoy certain tax benefits. The interest on a margin loan or a home loan may allow a tax deduction because these costs are considered “necessarily incurred.” However, it is important to take note that borrowing money for investment only makes sense if the return on investment after taxes are deducted is greater than the total cost of the loan with the fees and interest included. Otherwise, this would be a very risky decision that may only give a negative return.
What are the risks involved in borrowing to invest?
Like previously mentioned, gearing involves risk. The more you borrow, the higher the risk involved because you will be obliged to pay the loan regardless of how the investment performs. The following list includes some of the major risks associated with gearing or borrowing to invest.
- The risk in investment income. When you borrow money to invest, there is no promise of earning an income greater than the amount invested. You may receive lower than what you expected.
- The risk in the interest rate. The interest rates on some loans are not fixed. They could rise by at least 2 percent and that’s something anyone doesn’t have control over. When this happens, it’s important that you make sure you’re still able to meet loan payments.
- The risk of losing your source of income. Another important consideration would be the possibility of losing your income. If you take out a loan, you have to make sure you have a secure source of income to cover the monthly dues. But do you have a contingency plan for when your income stops due to reasons like redundancy, injury or sickness?
- Capital risk. Depending on what you have chosen to invest in, the value of your investment may not be enough to cover the entire loan. Therefore, be sure to consider other sources of funds and make sure you have enough money to take care of the remaining loan balance.
Gearing or borrowing money to invest is an extremely risky financial strategy. This is only highly recommended for experienced investors only. To help you decide, you may ask yourself the following questions.
- Besides your salary, do you have other sources of income to cover the loan?
- Are you able to sustain it for several years considering that gearing is a long term strategy which usually spans between 5 to 10 years?
- Do you have a high marginal tax rate that will enable you to take advantage of tax benefits?
- Do you have flexible plans to allow changes in career or personal life that will impact your financial stability?
Borrowing to invest isn’t really for everyone. Use this guide to help you think and carefully decide if gearing is the best decision for you.
Shall you decide to go the route of borrowing money for an investment, it is best to choose a financial institution that offers the best loan rates like credit unions. Please feel free to contact Calcite Credit Union for more information.