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Borrowing to invest is a popular strategy for those looking to build wealth. The primary benefit of gearing is that using borrowed money gives you a greater starting balance, magnifying your potential gains and/or allowing you to access assets with a high cost of entry. The common example, of course, is property, which is extremely difficult for the average person to access without substantial borrowings. With shares and other financial assets, you can use the same strategy.
Most investors who borrow to invest are also keen to use the tax advantages that borrowing offers – being able to deduct the interest cost from assessable income. For high income earners, this can be particularly attractive. The dynamics of this strategy have changed as interest rates fell to 0.1% during Covid and have since returned to their long term average.
As rates have risen over the last twelve months, the likelihood of the income from your investments exceeding your interest cost has fallen. As a result, it is increasingly likely you will incur an income loss with geared investments. This loss can be offset against your other assessable income such as salary, however it is obviously counter-productive to make a loss on your investments over time, and you should only engage in this strategy, known as negative gearing, if you are confident that the value of your investment will grow sufficiently to exceed these losses.
One strategy investors have used to give themselves certainty about rates, and to improve their tax position in the current year, is to prepay their interest. You may be able to pay up to twelve months’ interest in advance, and claim the deduction in the current financial year. This strategy allows you to lock in a fixed rate of interest for a full year, which is attractive if you’re concerned about further rate rises, and you can repeat the process annually, or switch back to a variable rate and monthly repayments at the end of your prepayment period.
Of course it is possible if you have high-yielding investments that your income exceeds your deductions, in which case your portfolio is said to be positively geared. As rates and income from your portfolio fluctuate, you may find your positively geared portfolio becomes negatively geared, or vice versa. You can generally use prepayment in either scenario, depending on your lender and the terms they offer.
It is important to speak to your lender as soon as possible if you wish to prepay. Rates and terms will differ, and the timing of the payment is critical – your lender will have a cut off date and time to ensure that any payment you make is received in the current financial year if you’re seeking to claim a deduction for it in 2022-23.
Regardless of whether you are currently positively or negatively geared, or you prepay your interest cost, gearing magnifies your potential gains - and losses. As a result, you should review your strategy regularly and ensure you keep a close eye on your investments. If you have a margin loan, or are thinking of using one, this is particularly important as the lender will require your security not fall below a specified limit (known as your loan to valuation ratio, or LVR). If you’re not comfortable with a high level of risk, gearing is probably not for you, and if you have questions, you may wish to seek advice from a professional financial or tax adviser.
This information has been provided WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by National Australia Bank Limited (ABN 12 004 044 937 AFSL 230686) (NAB) in preparing this material. NAB does not warrant or represent that the information, recommendations, opinions or conclusions contained in the material (“Information”) are accurate, reliable, complete or current. The Information has been prepared for information purposes only. Any statement as to past performance do not represent future performance. The Information is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, NAB recommends that you consider whether it is appropriate for your circumstances.