As a property and share investor for more than 20 years, I believe the use of gearing (borrowing) can be a legitimate means to purchase assets, but gearing is not an investment in itself: it is simply a means to invest with associated costs and extra risk.
Many of you will already be aware of my previously published views on the ‘hysteria’ surrounding the most recent versions of the SMSF limited recourse borrowing products.
Over the years, I have spoken to thousands of Australians about super and finance and they share their stories with me about good and bad investments. I’ll share one horror story with you about the misunderstandings that sometimes follow the fascination with packaged borrowing products.
During the months following the GFC, a woman in her fifties explained to me that she had a margin loan and it hadn’t performed that well. (A margin loan is a borrowing arrangement to purchase shares, and the shares are used as security for the loan. SMSFs cannot use margin loans.)
My investment alarm bell was ringing loudly in my head when I asked her what she had invested in with her borrowed money. She responded: “A margin loan of course. I always wanted to have a margin loan”.
It seems that her adviser either didn’t tell her what shares she had purchased, or she didn’t listen to him, or she didn’t understand what he was saying. As it turned out, her money was invested in one shareholding and after some digging we discovered that she had invested in one of those companies that imploded during late 2008.
The woman has nothing to show for her so-called investment, and she had to take out a larger mortgage on her house to repay the margin loan. The horror wasn’t that she lost her money, although that was bad enough, the horror was that she thought the loan was the investment and had no idea what she had invested in. The financial tragedy for this woman is that she now has a bigger mortgage because of her financial misunderstanding.
The moral of this tale is to understand the financing and investment decisions that you make.
Superannuation funds have always been able to buy direct property but the problem for most super funds is that the fund didn’t have sufficient cash to purchase the property outright. The ability to indirectly borrow money has opened up the possibility of direct property investment.
If you do your research and focus on the underlying investment rather than becoming distracted about being involved in the latest ‘hot’ product offering, then gearing and super can be relatively happy marriage.
The following is an extract from my book DIY Super For Dummies, explaining my views on gearing and borrowing within super:
Using borrowed money to invest can be a popular way to accelerate wealth accumulation. Borrowing to invest is also known as gearing, and involves an individual borrowing money to buy an income-producing asset. The income earned from the geared asset is then used to cover the expenses in purchasing and maintaining the asset, including repaying the loan. If the costs of investing, including interest payments, are greater than the income earned on the asset, individual taxpayers can then offset other income with the loss on the geared investment.
Borrowing to invest is a higher-risk strategy that relies on the investment returns or tax benefits associated with such a strategy outweighing the interest costs. Any loan that you take out still has to be repaid, which means the returns and tax benefits on that geared investment would at least have to deliver the costs of borrowing money to make the strategy worthwhile.
A major advantage of gearing is the ability to invest in more investments, or in an asset that is worth a greater amount of money, because you have more money to invest. Taking such an aggressive approach can increase your investment earnings if the value of your investment portfolio increases. A distinct drawback of gearing, however, is that using such a strategy can dramatically increase your losses when the value of the investment portfolio falls.
When borrowing to invest, the assets that you invest in are usually used as security for the loan, which means the bank has an interest in the investment. If you can’t repay your loan, then the bank can claim the property or shareholding, and can potentially demand more money from you if the sale of the asset delivers less money than the amount borrowed.
… You’re going to hear a lot of puff about [limited recourse borrowing arrangements]. Despite the hype, a [limited recourse borrowing arrangement] isn’t a magic pill that miraculously delivers you a stupendous property investment. The arrangement is simply that — an arrangement, rather than an investment. You, or the product promoter offering the borrowing product, have to select a suitable property investment for your fund. The borrowing arrangement then enables that investment to take place.
For example, you may be able to access a product that enables your SMSF to invest in residential property, provided you have 25 per cent of the purchase price plus enough cash to cover buying costs, including stamp duty. Another product on the market allows a SMSF to buy commercial property, provided the SMSF can cover 45 per cent of the purchase price plus buying costs.
Purchasing property (or any type of asset permitted by the super rules) by using a limited recourse borrowing arrangement can be a legitimate option for SMSF investors. When property values are rising, geared products enable to you to accumulate wealth at a much faster rate because you have access to the returns on more assets. In falling markets, however, your losses are also greater when you borrow to invest.
What matters when investing, whether you use borrowed money or not, is the quality of the underlying property investment. You also need to be mindful of the costs of such an arrangement. As a SMSF trustee, you need to ask yourself whether the expected returns on the investment justify the costs of the borrowing arrangement. The property products aren’t necessarily cheap, and you may discover you’re being charged several levels of fees.
… My view of limited recourse borrowing within SMSFs is that just because you can, doesn’t mean that you should. You can expect to read a lot of hype and hoopla about gearing within SMSFs, as if the act of gearing is an investment in itself. My reservations about some of the limited recourse borrowing products on the market is that investing in this way is expensive and you have to do your sums about the net benefit of such an investment approach. Don’t get distracted by the complicated structure of such products. You need to ask: Is the expected return on the property behind the borrowing arrangement going to exceed the annual interest costs, any management charges, and any additional establishment and add-on costs that the product promoter is going to charge?