Gearing up for wealth creation

Gearing for investment can cover a range of products and strategies. Paul van Rooyen examines gearing in home equity and margin lending as part of a wealth creation strategy.

Many clients have reaped the rewards of investing in the sharemarket, and after seeing interest rates head down over the last few months, are now more receptive to the idea of borrowing to expedite their wealth creation.

Gearing can be a very effective strategy to both increase wealth and do it ta effectively. There are many gearing strategies available to clients - this article looks at two of the simplest and most popular strategies: gearing against the equity in the home (the 'home gearing strategy'), and margin lending.

In both of the strategies we consider here, we assume the client gears into an Australian shares based investment. This appeals to most clients as:

- The costs of gearing into Australian shares are generally fully tax-deductible. If a client chooses to gear into an international investment, the tax deduction may be limited to the amount of income actually received from the investment.

- Australian shares have historically had consistently strong long-term returns.

- Australian shares can generate very tax-effective income (via franking credits).

Owning a home is the great Australian dream, and many clients assume that pouring all available funds into clearing the home loan is the smartest thing to do. However, this means there's no money left to invest and build wealth.

So why not do both? With a home gearing strategy, it's possible to build substantial wealth, as well as pay off the home loan a lot sooner.

This strategy generally assumes that a client has substantial equity in their home, surplus monthly income to invest, secure employment, and a long term investment horizon of five years or more.

The best way to illustrate how a home gearing strategy works is through a case study with an example of a couple's position, had they set up the strategy over 10 years ago, in December 1990.

Their current joint annual gross income is $93,000, an outstanding amount of $80,000 exists on their home loan and they contribute $2600 per month to the investment strategy.

First, let's assume they took out an interest only investment loan of $100,000, secured against their home. They invested the $100,000 in an Australian shares based managed fund. The interest costs and fees on the investment loan were fully tax-deductible and over the 10 year period they paid just over $103,000 including interest and fees on the loan.

Next, they used the rest of their surplus income, the income from their managed fund, and tax refunds to reduce their home loan balance. Their existing home loan of $80,000 was paid off after three and a half years at a total cost of nearly $101,000, including interest and fees.

Once the home loan was paid off, over the next six and a half years they invested their previous home loan repayments as well as the rest of their surplus income and tax refunds into their managed fund. They also started reinvesting the managed fund income. In total this represents nearly $160,000 in funds invested.

Added to the original $100,000, this equals just under $260,000 which when combined with capital growth and reinvested income from the investment of $247,260 results in an overall investment value of $507,000.

Finally, in December 2000 they cashed out their managed fund, paying capital gains tax of $38,500 and paying off their investment loan. In this example they would have been left with $368,426 cash and their home loan would have been paid off in full.

Our case study shows, very simply, the 'multiplier' effect that gearing can have on a client's investment returns (we ignore the cost of funds, and tax). We find line charts are very useful to use when demonstrating this effect to clients, as they show not only the increased final balance, but also the increased volatility along the way.

In the second example, this time using a margin loan, we assume a client had $20,000 to invest in an Australian share managed fund in December 1995.

If they simply invested the lump sum, by December 2000 it would have been worth over $35,000 - a healthy gain.

But what if they had also borrowed $30,000 and invested the entire $50,000 in the fund? The geared portfolio (net of the loan) would have grown to over $58,000, substantially outperforming the ungeared portfolio.

Of course it's important to remember that, as with any investment borrowing, their is some risk involved. Just as gearing can increase gains, it can also magnify losses. Before making any decision to borrow for investment purposes, it's important that clients seek advice from a financial adviser and independent tax adviser.

Home gearing has two key advantages over using a margin loan when sourcing the funds for a gearing strategy:

the interest rate is generally lower, and

the client will not have to meet margin calls if the value of their investment falls substantially.

The main disadvantage is also the reason the interest rate is usually lower - the fact that the client's home is used as security. Anyone considering the strategy needs to be aware that their home will be at risk should they have difficulty meeting the interest repayments. This risk can be mitigated by taking out income protection insurance.

Paul van Rooyen is the head of retail business development with Westpac Financial Services