'Leverage' - the definition according to the Oxford Dictionary is ‘the exertion of force by means of a lever; means of accomplishing a purpose, power, influence’. The definition according to Investorpedia is ‘the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment’. To the everyday investor, leverage may simply be described as ‘debt; fear; catalyst of the financial crisis; sub-prime; greed’.

In this article we focus on the second definition, ‘the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment’, to re-iterate the merits of borrowing to invest as an efficient and tax effective long-term investment strategy, but only if appropriately implemented.

What is gearing?

Gearing, is the process of borrowing money to invest. Just as you would take out a loan to buy a home, you can borrow money to invest in other assets such as shares, managed funds and investment property. The reason one would do this is to invest a greater sum of money and if the investment performs well, you will benefit from potential greater returns. However, if the reverse happens and there is an investment downturn, as we have all witnessed over recent times, then the more money you have invested, the more you stand to lose.

Ways to gear

Three common ways to gain leverage, or to gear your investments, include, home equity, margin lending and capital protected loans. Below we briefly describe each of these methods and their respective pros and cons.

Home equity loan

A home equity loan is borrowing against the existing equity in your home. This allows you to release the capital tied up in your home (usually up to 80% of its value including any existing debt) and use it to reinvest into income producing investments. You can establish a home equity loan by setting up a redraw facility within your existing home mortgage or by arranging a line of credit. A home equity loan provides access to low interest rates, low fees, no margin calls, and repayment (interest only, principal and interest, redraw, line of credit), borrowing and investment flexibility. This type of equity loan however, does introduce a ‘lifestyle risk’ by putting lifestyle assets (your home) directly at risk in the event of default.

Margin lending

A margin loan is a way to borrow up to a set percentage (usually up to around 70%) of selected listed securities and managed funds. Your initial investment can comprise cash investments, approved securities (shares and managed funds) or a combination of both. You supply these assets and the lender loans you the money for further investment purposes. A lending ratio (also known as the loan-to-valuation ratio or LVR) applies to each security and this determines how much you can borrow. The value of your securities will therefore determine the amount you can borrow, which is calculated daily.

Compared to home equity loans, margin loans are more expensive, attracting a higher interest rate due to the underling security being more volatile, ie shares vs your family home. They may also attract higher fees. They offer repayment flexibility and in normal circumstances you are not usually required to make any principal repayments on your loan; however, you are exposed to margin calls (see below for a description of a margin call). They offer good borrowing flexibility as well as investment flexibility, with a large list of approved investments (despite the list having narrowed somewhat in recent times). One of the main risks with this type of borrowing is ‘LVR risk’ which could see the LVR on any one security reduce, or completely disappear (go to a nil percentage) overnight.

As mentioned, one feature of the margin loan is the possibility of a margin call, which no doubt became all too common a theme in the lead up to and throughout the recent financial crisis. Put simply, a margin call will be triggered when the balance of your margin loan (the amount you have borrowed) exceeds your loan limit by more than your allowed buffer. This becomes a possibility in down markets, when the value of your security may fall, meaning your loan limit will fall, which in turn leads to a fall in the value of your buffer. In the event that your outstanding loan balance exceeds your new loan limit by more than the new buffer, than you will need to meet a margin call, which entails depositing some cash into your loan, selling some assets and using the cash to repay some of the loan, or transferring in some new assets. All these options work to restore the buffer between your margin loan and loan limit.

Capital Protected Loan

A third method of gearing is what is known as a capital protected loan. Under this option a limited recourse loan is used by the investor to borrow up to 100% of the value of the underlying investments. With a limited re-course loan, if the investor (borrower) defaults on the loan the lender is limited in the action that can be taken to recover the balance of the loan. This limited recourse feature ensures that the investor can return the shares and/or units in managed funds to the lender in full satisfaction of their outstanding obligations under loan.

Similar to a margin loan, this investment option attracts a higher interest rate, given the volatility of the underlying security, as well as the protection cost and there are a number of fees attached to reflect more complicated structures. There are no margin calls and whilst the loan is limited recourse, there is full recourse on the interest. There is little flexibility in interest repayment (usually interest only or interest in advance loans) as well as little investment flexibility – usually the provider will offer a small suite of approved investments. The products are also subject to Capital Protected Borrowing Rules which limits the deductibility of interest costs.