Borrowing to invest: gearing magnifies everything

Gearing — also called leverage — just means borrowing money to invest, so that a bigger pile of money faces the market than you actually own. Moneysmart's guidance opens without ceremony: borrowing to invest is a risky business — you get bigger returns when markets go up, and it leads to larger losses when markets fall. The lever has no opinion about direction. It multiplies whatever the market does, in whichever direction the market does it.

The mechanics are simple enough to hold in your head. The borrowed dollars join your own, so every market move lands on the whole portfolio — but the loan itself never shrinks with the market. Whatever the portfolio gains or loses is absorbed entirely by your slice, which is what magnifies the outcome. The arithmetic is durable: borrow a dollar for every dollar of your own and you've doubled your exposure, so a given move in the market becomes roughly double that move on your own money — before a cent of interest is counted.

The downhill side is steeper than it looks, because losses and gains aren't symmetrical on the way back. A 50% fall needs a 100% rise just to get back to where you started — and that's true for any investor. Gearing digs the hole faster and deeper: in Moneysmart's words, borrowing to invest increases the amount you'll lose if your investments fall in value. A magnified fall means an even taller recovery hill, climbed while the interest metre keeps running.

The most common way retail investors gear into markets is a margin loan — a loan for buying shares, exchange traded funds or managed funds, secured against the portfolio it buys. The lender watches one number: the loan-to-value ratio (LVR), which per Moneysmart is the value of your loan divided by the value of your investments. The loan contract sets an agreed maximum level, and your side of the deal is to stay under it — the current maximums live with the lenders, and Moneysmart's page describes how the ratio works.

Here's the trap in the design: a falling market raises your LVR without you borrowing another cent, because the loan holds still while the investments shrink underneath it. Go over the agreed level and you get a margin call — a demand from the lender to bring the ratio back down, on a deadline measured in hours, not weeks. Moneysmart lists your three options: deposit cash, add more investments as security, or sell part of the portfolio. Notice when that menu is served — always after prices have fallen, which is precisely the worst time to be a forced seller.

That forced sale is what Moneysmart calls capital risk: the value of your investment can go down, and if you have to sell quickly it may not cover the loan balance. And the security doesn't have to be the portfolio. Some lenders let you borrow to invest using your home as security — with the consequence Moneysmart spells out plainly: you could lose your home if the investment turns bad.

Everything so far assumed the market moves. The interest bill doesn't need it to. Moneysmart's sentence is complete on its own: you still have to repay the investment loan and interest, even if your investment falls in value. A geared portfolio pays for its lever in flat markets, in falling markets, in sideways years when nothing happens at all. Your own money can sit through a bad year and simply be worth less; borrowed money sits through the same year and sends you a bill for it.

That standing cost sets the hurdle. Moneysmart's test: borrowing to invest only makes sense if the return, after tax, is greater than all the costs of the investment and the loan. Not "makes a profit" — makes a profit after interest, fees and tax, every year, just to break even. A geared investment starts each year behind by the interest bill and has to earn its way back to zero before it earns you anything. What that hurdle is in dollars depends entirely on rates and fees this page won't print — Moneysmart's borrowing-to-invest guidance is the place to start when you're looking at real loans.

Two of Moneysmart's named risks live on this side of the ledger. Investment income risk: the income from an investment may be lower than expected — dividends get cut, distributions shrink — so make sure you can cover living costs and loan repayments even if the investment pays you nothing. And interest rate risk: on a variable rate loan, the rate and the repayments can rise, lifting the hurdle mid-race without your investment being consulted.

Moneysmart's classification is one sentence long: borrowing to invest is a high-risk strategy for experienced investors. It also frames gearing as a medium to long term strategy — borrowed money and a short horizon are a bad pair, because a magnified dip with no time to recover becomes a realised loss with a loan still attached. That sits inside the general rule from Moneysmart's investing guidance: find investments that fit your risk tolerance and your investment time frame — and gearing turns the risk dial up on whatever it touches.

For those who do proceed, Moneysmart's risk-management list is about building slack into the structure: don't borrow the maximum on offer, keep up the interest payments, keep cash you can reach set aside for emergencies, and diversify — spreading money across and within asset classes lowers a portfolio's risk, and diversification helps protect you if a single company or investment falls in value. A concentrated geared bet stacks the magnifier on top of single-company risk, which is the combination margin calls are made of.

Which gives you the honest disqualifier: if a margin call would sink you — no spare cash to meet it, an income that couldn't cover the repayments without help from the investment — then gearing is not for you, whatever the projected returns look like. There's no shame in that conclusion; it's most people. And Moneysmart's final word is the right one: if you're not sure whether it's right for you, speak to a financial adviser — Financial advice covers how to find a licensed one.