Your guide to gearing
By Robert Wright /August 21,2023/
There are a number of considerations when it comes to gearing, the investment assets you may choose to gear and the way you structure your debt.
A gearing strategy can be set at three levels:
- Positive gearing – where income from the investment exceeds the interest payable on the loan.
- Neutral gearing – where income from the investment is equal to the interest payable on the loan.
- Negative gearing – where the income from the investment is less than the interest payable on the loan. The excess interest expense is an allowable deduction against other assessable income, which for a taxpayer on the top marginal rate is currently worth 47% (inclusive of the Medicare levy).
Investing in growth assets such as shares or property using borrowed funds can be one of the most effective ways to accumulate wealth over the long term.
Investors are solely relying on a future capital gain when undertaking a negative or neutral gearing strategy. Negative gearing is tax effective in that the interest expense is fully deductible against the income generated by the geared investment and other assessable income. There are also other tax breaks such as the deductibility of depreciation (for property) and franking credits (for shares) to help subsidise the cost of the investment. In addition, for individuals, 50% of any capital gain is exempt from tax where the investment is held for at least 12 months.
Positive gearing strategy
If $100,000 were invested for a year in assets that produced a return on investment of 10% per annum, the total return on investment would be $10,000.
If the investor had also used a gearing strategy and borrowed $50,000 (at a cost of 7% per annum) and invested this in the same assets producing the same 10% per annum return, the return on investment would be 10%, less the cost of finance (7%) – that is, a net additional return of $1,500 using someone else’s money.
The net return can be greater than this when the tax deductibility of interest is taken into consideration.
The below examples of negative gearing illustrate how the negative cash flow from the investment can be offset by the deductibility of interest plus other tax breaks.
Negative gearing an investment property
Sarah earns a salary of $200,000 and borrows $400,000 to buy an investment property. The property generates rental income of $20,000 per annum while interest expense on the loan (interest only with no principal repayments) is 7% or $28,000 per annum. In addition to the deductible interest expense, there are the following ‘non-cash’ deductions:
- $2,500 depreciation
- $4,500 building amortisation (2.5% based on a construction cost of $180,000)
|Without negative gearing strategy
|With negative gearing strategy
|Non-cash property deductions
|Tax payable (incl. Medicare levy)
The difference in cash flow of only $950 has been assisted by the $7,000 tax deduction for the non-cash depreciation and building amortisation expenses.
These examples demonstrate the worth of tax deductions to an individual on the top marginal tax rate in the first year of a negative gearing strategy. Over time, negatively geared investments can become positively geared – especially when rental income or dividends are reinvested.
Couples with one person on a higher marginal tax rate than the other, should carefully consider who should be the borrower and owner of investments over the long term. While initially it may be tax effective to have a negatively geared investment in the name of the person with the highest tax rate, if it’s expected to become positively geared in the future, it may be more effective to have the loan and investment in the name of the person with the lower marginal tax rate from the outset. Especially when you consider the potential capital gains tax, stamp duty and loans fees that might be incurred in transferring the investment and loan.
Trusts and companies can also negatively gear investments, however the following should be considered:
- Trusts and companies cannot distribute losses, they need to be carried forward and offset against future assessable income.
- While the company tax rate is 30% for companies that are not base-rate entities which have a tax rate of 25%, companies are fully assessed on capital gains as opposed to the 50% discount applied to assets held for 12 months or more by individuals and trusts.
Negative gearing a share portfolio
Sarah earns a salary of $200,000 and borrows $400,000 to invest in a share portfolio. The share portfolio generates a dividend yield of 4% fully franked, while the interest expense on the loan (interest only loan) is 7% per annum under a line of credit secured against her home.
The below table illustrates the impact the negative gearing strategy has on Sarah’s cash flow.
|Without negative gearing strategy
|With negative gearing strategy
|Imputation gross up
|Tax payable (incl. Medicare levy)
|Tax payable (incl. Medicare levy) and after franking credit
The difference in cash flow is $2,726 which is approximately 0.7% of the investment portfolio. Sarah hopes that her after-tax capital gain will be greater than this cash flow loss.
Understanding your investment options
By Robert Wright /August 21,2023/
Investing is full of jargon and technical terms that can make getting started or managing your investments seem intimidating. Here are some of the key terms to help you better understand the different options available to you.
Common investing terms
There are a few terms that you’ll see repeated when we’re talking about investing.
Bonds – Bonds are a way for corporations or governments to receive a loan from investors for a promised rate of return over a specific period. Bonds can be issued to pay debts, build new facilities or raise funds for future growth.
Cash – Cash investments are savings accounts and other easy to access funds like cash management trusts and money market funds. Cash investments are stable and low risk, generally growing slower than inflation or the increase in prices of goods and services over time.
Diversification – Having a diverse group of investments means that you spread your investments across different companies or sectors (for example, shares or fixed interest). This way, if one sector underperforms or has a loss, you have other investments that may perform better and help balance out any losses.
Another way we diversify our investment options and portfolios is by using different investment managers, with different approaches to investing. In some cases we use multiple investment managers in the same option. These are called multi-manager portfolios.
Dividends – Dividends are a portion of profits or earnings paid to shareholders. They are paid on a regular basis and in some cases can be reinvested into the business in the form of more shares. This can provide shareholders with ongoing income.
Domestic Markets – Domestic markets, shares or companies refers to the variety of investments that are connected to that country, either through where they operate or the investment exchanges on which they reside. In Australia, we would refer to Australian bonds as domestic bonds. Likewise, a US-based fund would refer to the US stock market as the domestic market.
Environmental, Social and Corporate Governance (ESG) – ESG is the consideration of an investment beyond its financial performance. It often includes social and environmental factors, like its impact on the climate, the gender or cultural diversity of staff and leadership or general benefit to society. Investors are increasingly applying these considerations as part of their investing decisions.
Equities – Equities are another name for shares. Equities can be bought directly on the share market or through an investment option.
Fees – A fee is the amount charged by a fund to manage your investments. Fees may vary based on factors including the cost to manage an option, the size of the investment and the management style.
Geared Investments – Geared or ‘leveraged investing’ is a way to borrow money in order to increase the size of an investor’s original investment. Geared investments are often made with higher risk assets like shares and property.
International and Emerging Markets – International markets can give investors access to a variety of investments including shares, securities, property or bonds from nations other than their own.
International markets can be volatile because of international trade relations or fluctuations in currency value. There is more risk with less stable countries, like those in economic or political turmoil, and less risk in more stable countries.
Emerging markets are international markets that focus specifically on growing and developing economies like China, Brazil or India.
Investment Manager – An investment manager is a professional person or organisation who has been appointed to manage money in an investment option on behalf of investors. One or multiple investment managers may be appointed to an investment option. They generally have specialised expertise in the area they represent, like property, bonds or shares.
Investment managers are selected for their strengths in certain areas as well as organisational stability, solid investment process and a history of strong performance. We also use a specialist investment consulting and research firm when selecting managers.
Managed Fund – A managed fund pools your money together with other investors to buy a variety of assets like shares, bonds or property. Managed funds can be invested in single or multiple asset classes and have single or multiple investment managers.
Risk – Risk in investing is about understanding, anticipating and accepting the potential for financial loss in an investment. All investing has an inherent level of risk.
Risk can be seen as an option underperforming against expectation. Investors can spread their risk by diversifying their investments.
Securities – A security is a way to purchase a portion of an asset such as infrastructure, a property, loan or business. For example, shares are type of security that makes it easy to purchase a portion of a business.
Securities can be bought, sold or traded. The value can change based on market conditions, the value of the asset, expected income or general market conditions.
Share – A share or stock represents the purchase of a portion of a business. The value can increase or decrease based on a variety of factors including general market conditions as well as industry and company performance and challenges.
Some shares have lower volatility and provide strong regular dividends without necessarily increasing in value.
Short Selling – Short selling, or shorting, takes place when an investor believes the price of an equity (like a share) will go down. They arrange to sell shares on the market with intention of repurchasing them for a lower price later on. A short position is generally very high risk and can result in large losses if the price of the equity increases.
Mandate – A mandate is an agreement with an investment manager that sets out how money will be invested. It includes performance benchmarks and expectations, acceptable investments and investment ranges.
A mandate’s structure means that the investments are managed in a unique way for our investors, different from the investment manager’s options with other organisations. This gives CFS greater flexibility around the option including administration and reporting to investors.
Product Disclosure Statement – A Product Disclosure Statement (PDS) is a review of all relevant product information for an investment option. You should always read the PDS before making any decisions about the relevant products. It offers information including the investment managers, risk measures, objectives and minimum suggested timeframe.
Units and Unit Pricing – The unit price tells you the value of the package of investments it contains. Investments are packaged in units that are made up of a variety of assets, like shares, bonds and property. Investing this way gives you the ability to invest in ways that you may not otherwise be able to access as an individual investor.
Reading an investment option
We use a standard description to quickly review and compare different investment options. Here’s what you should look for:
A sentence or two on what the investment option is designed to achieve and the timeframe to achieve it.
Minimum suggested timeframe
How long an investment professional suggests you hold, or remain invested in, an option in order to achieve the stated investment objective.
This is only a suggestion and should not be considered personal financial advice. Because financial markets can be volatile and unpredictable, it’s good to regularly review your investments with a financial adviser to ensure they meet your needs.
A snapshot of the expectation that an investment option will deliver a similar number of negative annual returns over a 20-year period.
Generally, the higher the level of risk an option has, the higher its return is expected to be. You should review the associated risks to see if the option is suitable for your needs.
A description of the way the investment option is structured with some details about its contents and the reasons why those investments were chosen.
A quick way to organise different options by their typical range. These categories are not standardised across the investment industry, so what is considered ‘growth’ in one organisation might be considered ‘moderate’ by another. You should read the full details of an option before making an investing decision. We’ll break down the different investment categories a bit later.
A quick view of the different assets, or types of investments, contained in an investment option. In some cases, the assets are given a range, (i.e. between 15-25%), which indicates the minimum and maximum ranges that may be held in the option at any time. The investment manager may make changes within that range for different reasons including market volatility. Not all investments offer an allocation benchmark.
Underlying investment managers
These are the professional investment managers and organisations that have been appointed to manage the money in the investment option. There may be one or more, which is known as a multi-manager fund.
Investment categories and asset classes
There are a few different ways we organise and categorise investments to make it easy to understand how they are structured.
Cash and deposits
Cash is invested in reasonably stable domestic currency, like bank bills. Cash is liquid, making it easier to quickly access funds as required. It also includes term deposits (money invested for a set period) and money market securities. Cash and deposits are generally low risk and provide a low, stable return.
Less liquid than cash and deposits, enhanced cash is invested in money market securities and some fixed interest securities.
Fixed interest investments are investments made with a guaranteed rate of return. These are usually issued by corporations, governments or financial institutions to raise funds. They have a set rate of return, which is usually higher than cash but lower than higher-risk options like shares. The return comes from interest payments from the bond issuer. The amount of that return can change based on interest rate repayments.
Alternative funds may include a diverse mixture of investments including hedge funds or commodity trading like oil or livestock. Basically, anything that falls outside of the traditional shares, property, infrastructure, cash or fixed interest categories are called alternatives.
Property investing generally involves buying a property or buying a stake in a building through a property security. These properties can be office spaces, industrial properties or retail. A company or trust (a group acting on behalf of the investors) generally hold, manage and develop these properties.
Infrastructure is a broad term that refers to physical assets. It may include public transportation, toll roads or utilities like water desalination. It may also include social infrastructure investments in public housing, hospitals or prisons.
Infrastructure investments or securities (a portion of the investment purchased on a public market) are generally expensive and have high upfront capital requirements. They also feature low ongoing operating costs and have a reasonably stable return.
The most recognised method of investing, shares are part ownership of a company. They are generally bought and sold on a public stock exchange. Because of the general volatility of the share markets, shares are considered a high risk asset.
Over time, however, they tend to outperform other asset classes. The amount of risk can depend on the particular company invested in or the industry or region they come from.
Risk measures and categories
Risk is broken down into some general categories in order to help organise different investment options.
Because there is no industry standard around the naming of the categories, the level of risk may vary between funds. What is a conservative investment with one fund may be considered a moderate investment with another.
Risk is generally broken down into the following categories:
|Estimated number of negative annual
returns over any 20-year period
|Less than 0.5
|0.5 to less than 1
|Low to medium
|1 to less than 2
|2 to less than 3
|Medium to high
|3 to less than 4
|4 to less than 6
|6 or greater
Source: Colonia First State
What to do when your fixed rate home loan term is ending
By Robert Wright /May 19,2023/
Many Australians were fortunate to lock in record low interest rates but this may be drawing to an end.
A large portion of mortgages will be approaching the end of their fixed term, leaving many households paying two to three times their current fixed rate.
In this article, we’ll explain what to expect when your fixed interest rate ends and how to prepare for it.
What happens when your fixed rate home loan ends?
When your fixed term is nearing its end, you’ll need to decide whether to re-fix your loan at a new rate, change to a variable rate or consider switching to a new mortgage provider.
If you don’t do anything before the fixed term lapses, on expiry your mortgage provider generally switches your loan to its standard variable rate, which can be much higher than some of the discounted options available to new customers.
The best thing to do is contact your provider and ask them about your options, including what rates they can offer you.
How to prepare
Consider reviewing your mortgage at least 3 months before the fixed rate expires, as this will give you time to implement changes if required.
Here are some steps to go about this:
1. Negotiate with your current mortgage provider
It’s worth speaking to your current provider in advance to find out what variable rate you’ll be paying. This gives you an opportunity to check out other rates available in the market and think about whether switching providers is a better solution.
You can also see if you can negotiate a better rate as this may save you a lot of effort in moving to a new provider.
2. Research what other mortgage providers are offering
Now is a good time to see how your loan stacks up against other loans out there. This will help you determine if you’re getting a competitive interest rate.
If you do find a better offer, switching providers can be a smart move but it’s important to look at the costs involved in switching, borrowing costs and switching fees, as these can often outweigh the benefits.
Before you make any decisions, crunch the numbers with an online mortgage switching calculator.
3. Consider re-fixing your loan
If you like the predictability that comes with a fixed rate loan, you can re-fix your mortgage with an up to date interest rate.
However, you will be locked into the new fixed interest rate for a period of your loan term, unless you choose to end the contract earlier which may result in break costs.
Be sure to also carefully check out the features of a fixed loan too, such as fee-free extra repayments, redraw and linked offset accounts. Many fixed rate loans do not provide these features.
4. Consider a split loan
If you’re struggling to decide between a variable or fixed rate, or if you’re keen on a combination of flexibility plus certainty, you can choose to have part of your mortgage fixed and part of it variable.
For example, you could have 60% of your loan on a fixed rate and 40% on a variable rate.
This approach can provide the best of both worlds. The variable rate component gives you flexibility, while the fixed portion shelters part of your loan from rising interest rates.
5. Get help from an expert
If you can’t decide which option is best for you, a mortgage expert may be able to steer you in the right direction.
Mortgage experts can look at your finances and recommend some of the best home loan options to suit your specific needs. They’ll also be able to guide you through switching to another provider if that’s the path you choose to take.
Get a home loan health check
A home loan health check could help you to:
- find ways to fine tune your loan
- get more certainty or flexibility on interest rate options
- reduce your repayments
- pay off your loan sooner.
6. Make extra repayments before your fixed rate ends
If it’s possible for you to do so, consider paying off as much of your mortgage as possible before you’re hit with a higher interest rate.
By reducing your mortgage balance before your interest rate increases, you could save a lot of money on interest payments before it moves to the new rate.
How to manage higher repayments
When your fixed mortgage rate finishes and your repayments start increasing, your finances may need to be reviewed to cope with the new reality of rising interest rates.
There are ways to help you save and potentially earn more money, which may compensate for the rate increase.
1. Review your budget
While it may not be an option for everyone, there are expenses you can cut back on such as:
- taking public transport to work to reduce petrol costs and parking
- online shopping habits
- expensive memberships that you don’t regularly use
- taking advantage of government and council rebates to reduce your energy bill
- switching to energy efficient appliances and lightbulbs
- reviewing your utility and insurance providers – there may be better deals on offer which could save you hundreds of dollars.
2. Increase your income
Looking for ways to increase your income can help you manage higher repayments once your fixed rate expires.
Consider asking your manager for a salary raise or look for a higher paying job.
You could also consider starting a side hustle like dog walking or online tutoring to make extra cash. Another option is to rent out a room or parking space.
3. Consider opening an offset account
An offset account is like a transactional savings account linked to your mortgage balance. The funds in this account can reduce the amount of interest you pay on your mortgage, so holding your savings here can be beneficial.
For example, if you have a $600,000 mortgage balance and $100,000 in your offset account, you’ll only be charged interest on $500,000.
Five charts on investing to keep in mind in rough times
By Robert Wright /May 19,2023/
- Successful investing can be really difficult in times like now with immense uncertainty around inflation, interest rates, issues in global banks and recession risks impacting the outlook for investment markets.
- This makes it all the more important to stay focused on the basic principles of successful investing.
- These five charts focus on critical aspects of investing that are insightful in times of market stress: the power of compound interest; don’t get blown off by cyclical swings; the roller coaster of investor emotion; the wall of worry; and market timing is hard.
Every so often the degree of uncertainty around investment markets surges and that’s been the case for more than a year now reflecting the combination of high inflation, rapid interest rate hikes, the high and rising risk of recession which has been added to in the last few weeks by problems in US and European banks. And all of this has been against the background of increased geopolitical uncertainties. Falls in the value of share markets and other investments can be stressful as no one wants to see their wealth decline. And so when uncertainty is high a natural inclination is to retreat to perceived safety. As always, turmoil around investment markets is being met with much prognostication, some of which is enlightening but much is just noise. I will be the first to admit that my crystal ball is even hazier than normal in times like the present. As the US Economist, JK Galbraith once said “there are two types of economists – those that don’t know and those that don’t know they don’t know.” And this is certainly an environment where we need to be humble.
But while history does not repeat as each cycle is different, it does rhyme, in that each cycle has many common characteristics. So, while each cycle is different the basic principles of investing still apply. This note revisits once again five charts I find particularly useful in times of economic and investment market stress.
Chart #1 The power of compound interest
This is my favourite chart. It shows the value of $1 invested in various Australian assets in 1900 allowing for the reinvestment of dividends and interest along the way. That $1 would have grown to $246 if invested in cash, to $997 if invested in bonds and to $781,048 if invested in shares up until the end of February. While the average return since 1900 is only double that in shares relative to bonds, the huge difference between the two at the end owes to the impact of compounding or earning returns on top of returns. So, any interest or return earned in one period is added to the original investment so that it all earns a return in the next period, and so on. I only have Australian residential property data back to 1926 but out of interest it shows (on average) similar long term compounded returns to shares.
Key message: to grow our wealth, we must have exposure to growth assets like shares and property. While shares and property have had a rough ride over the last year as interest rates surged, history shows that both will likely do well over the long term.
Chart #2 Don’t get blown off by cyclical swings
The trouble is that shares can have lots of (often severe) setbacks along the way as is evident during the periods highlighted by the arrows on the previous chart. Even annual returns in the share market are highly volatile but longer term returns tend to be solid and relatively smooth, as can be seen in the next chart. Since 1900, for Australian shares roughly two years out of ten have had negative returns but there are no negative returns over rolling 20-year periods.
The higher returns that shares produce over time relative to cash and bonds is compensation for the periodic setbacks they have. But understanding that these periodic setbacks are just an inevitable part of investing is important in being able to stay the course and get the benefit of the higher long term returns shares and other growth assets provide over time.
Key message: short term, sometimes violent swings in share markets are a fact of life but the longer the time horizon, the greater the chance your investments will meet their goals. So, in investing, time is on your side and it’s best to invest for the long term when you can.
Chart #3 The roller coaster of investor emotion
It’s well known that the swings in investment markets are more than can be justified by moves in investment fundamentals alone – like profits, dividends, rents and interest rates. This is because investor emotion plays a huge part. This has been more than evident over the last year with all the swings in markets. The next chart shows the roller coaster that investor emotion traces through the course of an investment cycle. Once a cycle turns down in a bear market, euphoria gives way to anxiety, denial, capitulation and ultimately depression at which point the asset class is under loved and undervalued and everyone who is going to sell has – and it becomes vulnerable to good (or less bad) news. This is the point of maximum opportunity. Once the cycle turns up again, depression gives way to hope and optimism before eventually seeing euphoria again.
Key message: investor emotion plays a huge role in magnifying the swings in investment markets. The key for investors is not to get sucked into this emotional roller coaster. Of course, doing this is easier said than done, which is why many investors end up getting wrong footed by the investment cycle.
Chart #4 The wall of worry
There is always something for investors to worry about it seems. And in a world where social media is competing intensely with old media it all seems more magnified and worrying. This is arguably evident again now in relation to uncertainty about inflation, interest rates and associated recessions risks. The global economy has had plenty of worries over the last century, but it got over them with Australian shares returning 11.7% per annum since 1900, with a broad rising trend in the All Ords price index as can be seen in the next chart, and US shares returning 9.9% pa. (Note that this chart shows the All Ords share price index whereas the first chart shows the value of $1 invested in the All Ords accumulation index, which allows for changes in share prices and dividends.)
Key message: worries are normal around the economy and investments and sometimes they become intense – like now but they eventually pass.
Chart #5 Timing is hard
The temptation to time markets is immense. With the benefit of hindsight many swings in markets like the tech boom and bust and the GFC look inevitable and hence forecastable and so it’s natural to think why not switch between say cash and shares within your super fund to anticipate market moves. This is particularly the case in times of emotional stress like now when much of the news around inflation, interest rates and recession risks seem bad. Fair enough if you have a process and put the effort in. But without a tried and tested market timing process, trying to time the market is difficult. A good way to demonstrate this is with a comparison of returns if an investor is fully invested in shares versus missing out on the best (or worst) days. The next chart shows that if you were fully invested in Australian shares from January 1995, you would have returned 9.3% pa (with dividends but not allowing for franking credits, tax and fees).
If by trying to time the market you avoided the 10 worst days (yellow bars), you would have boosted your return to 12.2% pa. And if you avoided the 40 worst days, it would have been boosted to 17.1% pa! But this is very hard, and many investors only get out after the bad returns have occurred, just in time to miss some of the best days. For example, if by trying to time the market you miss the 10 best days (blue bars), the return falls to 7.2% pa. If you miss the 40 best days, it drops to just 3% pa.
Key message: trying to time the share market is not easy. For most its best to stick to an appropriate well thought out long term investment strategy.
Source: Shane Oliver, AMP