Debt, gearing, leverage and money management – the simple truth

Gearing is an important part of money management.

Essentially, it is borrowing additional funds to invest or purchase an asset. Often, this is also referred to as applying leverage on an investment.

A very common type of gearing in Australia is mortgage, whereby you borrow money or use debt to purchase real estate – an investment property or a home. Similarly, you can use a margin loan or a line of credit to invest into the share market.

There are various reasons why anyone would borrow to invest. For example, getting a mortgage would mean you get to own your piece of real estate sooner rather than later. Or you might like the idea of reducing your tax bill whilst creating long-term wealth through investments. This is not anything magical or new. For “Game of Throne” fans, it is an age-old concept such as the “Iron Bank of Braavos”.

However, let’s put the emotional aspect aside as to why you would want a mortgage or what creating long-term wealth would mean to your life. There is a rational side that often does not get the attention it deserves.

That is, borrowing to invest amplifies your investments.

The below is a highly simplified example to illustrates this point.

 

Money Management - What is gearing or applying leverage to investments? - Plutus Financial Guidance

 

The difference between scenario 1 and scenario 2 is that on the upside, you gain more and on the downside, you lose more.

The end results are simply amplified and more extreme.

Gearing or using leverage is therefore a riskier approach to investing.

This same logic applies if you have a mortgage or if you are borrowing to invest in real estate. Based on the graph below, Australians love this approach.

Money Management Australian Mortgage Debt to GDP

Source: SMH

Using debt, gearing or leverage aids long-term wealth creation and is part of everyday money management. It is a riskier approach which is not new to Australians and can apply to various types of assets or investments including small businesses, shares or real estate. Gearing can be done through different ownership structures such as superannuation and self managed super fund, which are important for retirement and transition to retirement needs.

Most people claim that their real estate will never drop to a zero-dollar value. However, the same thing can be said about the ASX 300, S&P 500 or FTSE 100 etc.

There is nothing wrong with real estate, it is an essential component of your financial health.

When it comes to using debt, proper money management is the key.

It’s important to take a sensible, optimised and disciplined approach.

Deploy an investment strategy that is long-term focused and balanced, to ensure your investments are exposed to a good mix of assets, as well as domestic and international opportunities. See my article on “Wealth creation via long-term investments” for more details. Don’t lose sight of the big picture. Think long-term, think global.