When it comes to buying property, there is no one size fits all approach. Lenders have a variety of ways of assessing you for a loan, but none of them consider your personal risk profit as part of the process. In other words, they work out how much you can borrow, and then offer it to you. But in doing so, whether you are comfortable with that level of borrowing, whether it is right for your circumstances and whether there will be tax implications, are matters which are not considered.
When you scale up to buy more property, you borrow more money to do so. The term ‘gearing’ relates to the process of borrowing to apply a leveraging effect to your own funds to invest in a greater number, or wider range of assets. The higher you gear an investment portfolio, the more you multiply the risk of loss, as well as the return. And so regardless of whether you are able to borrow more, and buy more, the important thing to consider is how you will personally feel about the level of borrowing required to scale up.
In addition to that, understanding how gearing impacts on risk and return is important for all investors, so that you can match your own needs and risk profile to suitable levels of gearing. An investor with a long time till retirement, a good income and sufficient excess funds has more appetite for risk, and so can probably afford to more highly gear and scale up more quickly, while an investor who may need the funds sooner and who has little chance of replacing lost funds, should adopt a lower gearing strategy.
Here are 3 different gearing levels, and the risks they present.
- Borrow 80-90%
Where you go hard and borrow every time you have a tiny amount of equity in your property, you only have a small margin for value swings, as any loss in value obliterates you bottom line. At this level, vacancy risks present the possibility of lost income, meaning you have to manage the mortgage alone. While tax advantages are higher due to more interest being paid, a tax break will only plug part of the gap between what comes in and what needs to go out. You should not borrow to these levels if you are nearing retirement, have job instability or if you currently have no capacity to save or invest in additional assets besides the property you are borrowing for.
- Borrow 60 – 80%
An investor with a medium time frame in which to invest, relative job security and an income which can facilitate additional debt repayment or additional investing, as well as a mid-range attitude to risk, should choose an LVR within this range. A fall in value of the security property is unlikely to result in total loss of personal wealth, and at these levels of gearing there is still a good amount of leveraging which enables quicker upscaling. Vacancy risks can be easier to manage if your loan commitments are not so high.
- Borrow less than 60%.
An investor with a short time till retirement, a limited amount of years available to work and a small amount of savings is well advised to keep their gearing levels below 60%. At this level, a good margin is built in to ensure that securing assets are not likely to be at risk and that, should property values fall, a nest egg in the form of remaining equity would still exist. It takes longer to scale up when you gear at lower rates, but a much greater level off safety is built in.
Wise investors usually maximise their gearing levels at 80%, and attack debt reduction with vigour and commitment to reduce this quickly. Remember that for every $1 of property you own, that’s $5 more you can buy with leveraging, so constant debt repayment and acquisition of equity is a crucial part of every property investment strategy!