Record low interest rates are making it harder for your money to keep pace with the rate of inflation. While it may be a struggle to grow your wealth in such an environment, low interest rates do mean that it is cheaper to borrow.
So why not take advantage of this opportunity by borrowing money to invest in growth assets such as shares or property? Gearing (borrowing) can be a great way to fast-track wealth creation although it must be remembered that it is a double-edged sword. While using borrowed money magnifies profits, it also magnifies losses. However, by borrowing sensibly and cautiously, and investing in quality assets, the benefits can outweigh the risks.
As well as boosting your returns, there are also tax advantages because you can offset interest paid on your loan against your income.
What are your options?
There are a number of ways you can borrow to invest including home equity loans, margin lending, warrants and internally geared managed funds. Each has its pros and cons so it is wise to get professional advice.
Home equity loans
As the name implies, home equity loans let you borrow against the equity you have built up in your home by using a redraw facility or an additional line of credit.
This method of borrowing is relatively cheap to service as you are only paying mortgage rates of interest. The downside is that you put up your home as collateral.
The second method is via a margin loan where you typically borrow somewhere between 30 to 50 per cent of the value of an asset. The lender will stipulate the maximum you can borrow, called the loan to value ratio (LVR).
If markets fall, your LVR will rise and if it rises above a certain level you have to pay extra money to rebalance your borrowing. This is called a margin call and may be requested at short notice, forcing you to sell some of the investment quickly (and at a bad time) to meet the call.
Warrants add leverage
Warrants, which are traded on the Australian Securities Exchange, give you exposure to an underlying asset for a portion of the price without the need for margin calls.
As a result, a warrant gives you leverage which means small changes in the value of the underlying asset result in larger changes in the value of the warrant. This magnifies gains and losses.
There are many types of warrants, each offering a different level of risk and leverage. Warrants can be on individual shares or on exchange traded funds which offer greater diversification.
The maximum you can lose is the amount you paid for the warrant. As the borrowing is non-recourse, you can walk away and only be liable for the loan.
Gearing made simple
The simplest alternative is to let a professional handle the borrowing for you with an internally-geared managed fund. The advantage here is that you don’t need to take out a loan yourself, risk your home as collateral or face a margin call.
Such funds are for investors seeking capital growth rather than income and should be viewed as a long-term investment as the funds are generally more volatile than the sharemarket in the short term.
You can also gear up your selfmanaged super fund with a limited recourse loan. The rules are complex so it is vital that you receive the right advice to make sure you comply with superannuation laws.
By adopting a borrowing strategy that aligns with your risk profile, you can turn today’s low interest rates into tomorrow’s gains.