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Share investors: Is negative gearing into shares a good idea?

Borrowing to invest—also known as negative gearing—is a risky venture that many embark on but only a few succeed at. It can be marred by risks if you don't get the correct financial advice or you don't have vast experience in monitoring and predicting markets.

Negative gearing into shares is where you borrow money to invest in shares and the interest accumulated from the loan is more than the amount of dividends earned from the shares.

In other words, in the short-term, negative gearing into shares is where you’ve had more cash go out (interest on the loan) than has come back in (dividends from the shares).

If that’s the case then, what’s the benefit from negative gearing into shares? And what are the risks involved?

Read our guide to find out…

What is your marginal tax?

When you are at the point where you are paying the highest amount of tax, also known as marginal tax, you are better set to make gains by borrowing to invest. Here you can often get a tax deduction on any interest payments made towards your loan.

However, you must be very careful here. This method only works if, after tax deductions, your investment returns are more than the costs involved in your loan. Otherwise, you may end up having to deal with negative returns.

Franked dividends

While franked dividends do not put money directly into your pocket, it is still worth mentioning that when you pay less tax, you have more money at your disposal to invest.

Franked dividends attached to shares come about because companies pay their taxes and then a portion of this “tax paid” amount is attached to the shares you buy from the same company. Once you receive payment by investing your money in franked dividends, you are relieved of paying any additional taxes on those dividends. This avoids taxing the shares twice.

Three benefits of negative gearing

There is a lot of talk about the risks of negative gearing but it also comes with some benefits for investors:

1. Tax credits

Investing in quality shares enables you to receive a tax credit on the dividends that you collect. This is made possible by the dividend imputation system (DIS). The franked dividends, as mentioned above, can have a positive effect on your cash flow. This is because the income attracts a small fraction of tax deduction.

2. Builds wealth

You can increase the ability to create more wealth by negative gearing because borrowing allows higher levels of investments than you could normally using your available capital. This means you could multiply your earning potential in a favourable market.

3. Make deduction claims for expenses and interest

Under the current taxation laws, you can make deduction claims for expenses and interest, offset against any assessable income you are making. This includes income such as business, investment or salaries.

Two risks of negative gearing

Of course, any form of investment carries risks, and here are some of those associated with negative gearing into shares:

1. Lower income

There is a high chance that the income you are able to make from the investment will be much lower than what you may have expected. For instance, if you borrowed money to buy shares, the company may pay lower dividends or even not pay any dividends to you at all.

2. Capital risks

What if the value of the shares you bought with the borrowed money turns out to be lower than you expected?

Anyone who borrows money to invest in shares is looking to make capital gains. However, there is no way of telling if the money you make will be enough to cover the remaining balance. It is wise, therefore, to have some money set aside to cover this risk.

Negative gearing into shares: Is it worth it?

Negative gearing is suited to those who are bold and ready to face the potential risks head-on. If you are quite new to negative gearing into shares, it is advisable to first talk to a business advisor. Our Perth-based team can guide you independently to help you see both sides of the coin and ultimately make an informed financial decision about whether it is right for you.

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