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Gearing - Borrowing To Invest

What is Gearing?

This is the act of borrowing Other People’s Money (OPM) to increase your returns.

Gearing is the ratio of your money to OPM, such as 10% your money to 90% borrowed (10 to 1). Except for residential property, most lenders prefer a gearing ratio of 5 to 1 or less. Depending on your circumstances and the type of investment, 2 to 1 is usually considered a safe gearing ratio, that is your money plus half again from the lender. The gearing ratio is also known as the Loan to Value Ratio (LVR or LTV) and expressed as a percentage – 5 to 1 would be a 80% LVR - as 1/5th of 100% is 20% (your equity) and the rest (80%) is the loan amount.

Why Use Gearing?

You could invest $500,000 of your own money in a residential property, but getting that much money would take most people a lifetime to achieve. Fortunately you only need 5-10% deposit (and purchase costs) to buy a property (in a normal market) and banks believe on the whole that your home is a secure investment and will lend you the rest.

Who Determines The Gearing Level?

Typically this is the lender. Banks manage risk differently at many levels, but at the consumer level the banks likes to see the LVR less than 80% as this gives a safe buffer in case you can’t make your payments. The buffer caters for a discount in a foreclosure sale and market fluctuations in pricing. A foreclosure is when you cannot make your payments and the bank takes back the property and sells it to get their money back. The banks use the funds from depositors to fund loans so they can’t afford to lose their depositor’s money or they would have a queue at the door with every depositor wanting their money back. With most of the money tied up in loans the bank couldn’t hand back all the money.

 

Simply put, banks make their money on interest from the loans they provide less the interest paid on deposits. It’s a small percentage using vast sums so the profits are usually in the billions. This is why the banks have to be so strict with your loan and why you have to be disciplined and honourable in paying it back. Please don't blame banks if you do not understand their rules, do your research. Having said that if you do not like the bank's service take your business elsewhere, I dont reward poor service or performance with my business.

Even Lenders Are Not Immune To Bad Gearing Decisions

The Global Financial Crisis was caused by many banks that over-lent money without sufficient reserves to fall back on if the market turned against them. The market did turn and banks ended up in a position where they lent much more than the assets were worth. Then they stopped lending to prevent a worsening of the situation so businesses and individuals who needed credit couldn’t get any to trade. This led to layoffs, plummeting asset values through high supply of distressed sales, and basically compounded on itself in a downward spiral. Australian Banks (and a few other countries) were largely spared the ferocity because they were strictly regulated to hold reserves to support their gearing levels. Risk management helped them survive relatively well.