This third article in the series on accelerated wealth creation provides an overview of gearing as a wealth creation strategy. Gearing is a strategy that enables you to leverage your income and equity, which may currently be under utilised.
Gearing: You’ve heard of it, but what is it really?
As one attendee at the IPWEA conference noted a few weeks ago, it seems that everyone’s talking about gearing as the holy grail of wealth creation. So it is possible that you have heard of it. But based on questions I’m commonly asked it seems there is only partial understanding of gearing. So here is a quick overview.
Gearing is a term used in wealth creation for leveraging your money. If you’re not familiar with leverage then picture a “see saw”, that wonderful mainstay of children’s playgrounds. Using a “lever” is a way to get more output for the same or less input. Or, to say it another way, leverage helps you get more reward for less effort.
Gearing is using someone else’s money to generate more wealth for you. Usually someone else’s money is provided in the form of a loan from a bank. The security for the loan is often property, direct shares or managed funds.
How Gearing Works
Simplistically, this is how gearing works:
- You start with some of your own money (e.g. $100,000)
- The bank adds some of their money as a loan (e.g. another $100,000)
- You invest the whole lot (e.g. $200,000)
- Along the way you pay the bank interest on the loan
- Presuming you’re a wise investor your annual investment return percentage is higher than the loan interest percentage
- When you sell you repay the bank the amount you borrowed but keep all the investment returns for yourself
- Your net wealth has grown a lot more than if you didn’t gear, so you are now wealthier.
The Good and the Bad of Gearing
The main advantage of gearing is that you get wealthier quicker. This presumes that your investments go well.
The main disadvantage results from the fact that the lever can go both ways; you can also get poorer quicker. That is the main risk you face for trying to use leverage to get more reward.
Other risks of gearing include:
- Your investments go up but not as much as you paid in loan interest, meaning you are now not as wealthy as if you’d not geared.
- You need to meet the regular loan repayments, so therefore need an alternate steady form of income (such as your salary).
- Even though gearing is a long-term strategy in the short-term you can be asked to repay part of the loan if the lender gets nervous about a drop in your investment value.
On top of the above list of gearing risks you have all the other risks associated with investing. Gearing magnifies the consequences if the risk eventuates. (Your fingers could get burned quicker.)
Gearing should be used appropriately and with caution. Here are some pre-requisites before considering gearing as a strategy for you:
- You need a very high tolerance of risk
- You need to have time and patience. This strategy requires you to have at least a seven year horizon before needing the money; in fact at least ten years is best. This time horizon matches the average cycle of investment markets.
- You should be able to afford to meet the loan repayments from your other income.
- You are a wise investor or are willing to pay one (i.e. a professional expert)
- Use growth oriented investments such as property and shares or managed funds that invest in those asset classes. These asset classes have a good likelihood of earning you more than you pay in loan interest.
- Protect your financial situation from disaster that would result in you needing to access your geared portfolio earlier than planned.
- The top priority for protecting your financial situation is protecting your income. This is two pronged: (1) Protect against injury or illness with income protection insurance; and (2) ensure your skills and knowledge make you very employable.
- Ensure the rest of your long-term investments are also invested aggressively. It is counter-productive to have conservatively invested superannuation whilst gearing outside of superannuation.
Time to Crank Up the Gears
If you have under utilised equity and cashflow you can accelerate your wealth creation by cranking up with gearing, just like on your bicycle.
Next issue we’ll cover gearing your underutilised home equity and the following issue we’ll talk about margin lending. Margin lending includes a wonderful feature called “instalment gearing” that is a wonderful tool for underutilised income.