This article was published on 17 July 2010. Some information may be out of date.

Getting into gear not always wise

The four most hateful words are said to be, “I told you so.” So I’ll put this another way: One of my key messages in seminars, books and columns over the years — that borrowing to invest is more dangerous than many people realise — is easier to “sell” these days than a couple of years ago.

Borrowing to invest — otherwise known as gearing — is most common in property investment. Back in the booming mid 1980s, many also borrowed to buy shares. But the 1987 crash put an end to that, leaving people with worthless shares and a debt to pay off.

Generally, such a sad ending is rare for a geared property investor. “You can’t go wrong with bricks and mortar,” has been a common claim — until recently.

It’s no fun watching people lose their properties in mortgagee sales in which the proceeds don’t even cover the mortgages. But it does give us a clearer understanding of how gearing can work.

Let’s look at what might happen to three people who start out with $100,000 each:

  • Ungeared Una buys a small $100,000 unit with no mortgage.
  • Lightly Geared Lisa puts a $100,000 deposit on a $200,000 home, borrowing the other $100,000.
  • Heavily Geared Harry goes for a $1 million home, with a $100,000 deposit and a $900,000 mortgage.

To make the numbers easier to follow, we’ll make the mortgages interest-only and ignore the costs of buying and selling property.

In our first scenario, property prices have grown 20 per cent by the time our threesome decide to sell.

Una’s $100,000 has simply grown 20 per cent to $120,000. Lisa gets $240,000 for her house, and repays her $100,000 mortgage, leaving her with $140,000. Her deposit has grown 40 per cent — double Una’s growth. Meanwhile, Harry receives $1.2 million. After repaying his big mortgage he has $300,000 left. His $100,000 has tripled. Wow!

Of course the mortgage borrowers had to pay interest over the period. But as long as mortgage rates were fairly low, Lisa would still be ahead of Una, and Harry would be well ahead. They have both benefitted from the growth not only on their own money but also on the bank’s money.

In our second scenario, however, property prices have fallen 20 per cent. Una needs to free up some of her capital for a family crisis, Lisa needs hers to fund some health expenses, and Harry’s income has fallen so he can’t make his mortgage payments. All are forced to sell, trading down for cheaper homes or moving in with others.

Una’s $100,000 has shrunk 20 per cent to $80,000. Lisa gets $160,000 for her house, repays her $100,000 mortgage, and is left with $60,000. Her deposit has shrunk 40 per cent. And poor old Harry gets just $800,000 for his place. He can’t even repay his $900,000 mortgage, so he’s left with no house and a $100,000 debt.

By the time we add mortgage interest payments, Lisa has done really badly, and Harry has done horribly.

Gearing an investment is like gearing in a car — the higher the gear the faster you go. You either reach your destination sooner or crash harder.

Our little story would, of course, be different if the three had been able to sit out the downturn. Over the long term, we always expect property prices to rise.

The moral, then, is: gearing increases risk as well as return. Before you gear an investment — especially if it’s high gearing — be confident you won’t get into a situation in which you would be forced to sell.

Mary Holm is a freelance journalist, a director of the Financial Markets Authority and Financial Services Complaints Ltd FSCL, a seminar presenter and a bestselling author on personal finance. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.