If you’ve spotted an opportunity to grow your wealth, it can often be difficult to find the capital to adequately exploit it. Most of us don’t have tens or hundreds of thousands of dollars lying around ready to be used, so we often turn to what’s known as leveraging, or gearing depending on your jurisdiction. This refers to the practice of borrowing funds to purchase an asset, in the hopes that the income from the asset after tax and/or its appreciation will cover the cost of taking out and servicing the loan.
This can be a great way to get a start, and is common practice for entrepreneurs who often take on debts to cover the establishment cost of a business, hoping to build the business into a profitable enterprise that will cover the cost of the loan. You should know a few things before you start leveraging however. Read on to find out more.
Be aware of the various risks
Borrowing to invest comes with four distinct major risks, each triggerable by a different change in your economic situation:
The first is investment income risk – this is the risk that the income you receive from the investment (i.e. dividends from shares or net profit from a business) is lower than you initially expected and does not cover the cost of servicing the loan.
The second is interest rate risk – if you took out a variable interest rate loan, what happens if the interest rate rose by 2%, or 5%? Would you still be able to service the loan?
The third is income risk – if there’s a latency period between buying the asset and the asset becoming profitable, what happens if your primary source of income (e.g. your wages) is affected because of sickness or redundancy? Do you have a back-up plan to service the loan?
The fourth is capital risk – this is a longer-term risk and refers to the value of the investment falling to such a level that were it to be sold, the proceeds would not cover the remaining balance of the loan. Do you have other funds with which to meet the shortfall?
Improve your cash flow and jump on opportunities
If you’re able to address these risks, borrowing to invest can be a hugely profitable undertaking. Common assets include investment properties (with tenants as a primary ongoing source of income) or shares (dividends and sale proceeds), both of which can be a great way to protect your finances into the future, with some smart planning.
If you’re looking for some financial advice about borrowing to invest, speak to a loan consultant today.