With interest rates so low is it a good time to borrow money to invest? In his blog this month Financial Adviser and Mortgage Broker, ROD LINGARD looks into the positive and negatives that investors need to consider before taking out a loan.
Australians are currently enjoying record low interest rates. Some economists are predicting that the interest rates will stay at historically low levels for some time to come.
This leads to an interesting question – should I borrow to invest?
At the most basic level, it is a simple equation. If the anticipated return of the investment exceeds the cost of borrowing the funds, then mathematically it makes sense to borrow for investment purposes.
With that being the case, why wouldn’t we borrow to invest, especially when we consider the record low interest rates?
The answer to that question is that returns are virtually never guaranteed, and so borrowing to invest always carries some inherent risk.
The major risks of borrowing to invest are:
- The potential to increase your loss — Borrowing to invest increases the amount you’ll lose if your investments falls in value. You need to repay the loan and interest even if your investment falls in value.
- Capital risk — The value of your investment may go down. If you have to sell the investment quickly, the value of the investment may be less than the balance of the loan.
- Investment income risk — The income from an investment may be lower than expected. For example, if you own property, you may have an extended period of no tenants. If you own a share portfolio, the companies may not pay a dividend.
- Interest rate risk — If you have a variable rate loan, the interest rate and interest payments could increase.
How can these risks be balanced?
Risk can rarely be eliminated completely, but there are ways to reduce the level of risk involved with borrowing.
- Time Frame – Set a long term time frame for your investments. Borrowing to invest is not a short term strategy. Generally speaking, a time from of 7 years should be a minimum.
- Investment Diversity – Diversifying across different asset classes, industry sectors and geographic regions reduces the risk of holding an individual asset.
- Budgeting and Cashflow Management – the ability to repay the loan from income sources other than the investment itself significantly reduces the risk.
- Moderation – don’t borrow the maximum. Start with a conservative level of borrowing compared to the asset value.
We’ve covered the most important risks, what about the benefits?
There are two possible advantages of gearing.
- You can increase potential profits
If you borrow money to invest in shares or real estate, and they increase in value, then you get the benefit of that gain on your original investment (capital gain) when you sell the asset (less the borrowing costs). Equally, you get the benefit of any dividends, bonus share issues or rents that may be made while you own the asset.
- You may obtain a tax benefit
Negative gearing is when your income from the investment is less than the cost of the investment (that is, interest that you are paying to your lending institution on the loan). The difference between the two amounts can generally be used as a deduction on your taxable income. Needless to say, the benefit of any tax deduction is dependent on tax rates payable by the investor.
Deciding whether to borrow money to invest depends on your own personal needs and circumstances.
If you are not sure, get advice from a licensed adviser, who is obliged under the law to look at your personal situation.
Rod Lingard is a Licensed Financial Adviser with Lifestyle Connexion and can be contacted on 0400 160 461. Financial Advice is provided by Rod Lingard – Authorised Representative No: 248734 of MASU Financial Management Pty Ltd | AFS Licence Number 231140 ABN: 78 069 358 498.
General Advice Warning: This blog is not designed to replace professional advice. It has been prepared without taking into account your objectives, financial situation or needs. You should consider the appropriateness of the advice, in light of your own objectives, financial situation or needs before making any decision as to what is appropriate for you.