How Gearing Makes a Difference

August 31, 2010

‘Gearing’ is similar to the gear of a car – its main function is to make things work harder for you with less effort. In our case we are talking about investment and getting the money to work harder on your behalf.

Gearing is all about good debt. Gear too highly and some void periods or drops in rental can kill you but gear correctly and your cashflow will benefit. Here is an example:

Let’s say you buy a house for $50,000. The rent nets at $900 a month. You borrow 30% at 10% for 5 years. Monthly income would be $900 – $319 mortgage payments = $581.

After 5 years, your $35,000 investment would have $34,860 rent income and $50,000 of equity after loan is paid off = 142% return on your money.

Let’s compare that with gearing the same house at 50%. Your monthly income would reduce to $900-$531 = $369, and after 5 years you would have $22,140 plus the $50,000 equity – while this is less than the first example, the investment was only 50% ($25,000) rather than 70% ($35,000) so the return on the $25,000 is $77,140 – same house, same rent, higher gearing – 208% return.

So in short – gearing higher means you employ relatively less capital, increasing your overall return.

Note that these examples do not involve any capital growth. One scenario that could illustrate how gearing can go wrong, would be when someone buys ‘for growth’ with a low yield, and high gearing (banks will sometimes still lend this way). For example, if I buy an apartment in London for $500,000 and get 70% lending at 5% interest for 30 years the net rent could be $2500 a month (6% NET yield) but the monthly mortgage payment would be $2201. In a no capital growth scenario, the investor is only getting cashflow of $3,588 a year from his $150,000 investment – at 2.39% less than a bank will give. However, the main danger of this is the risk to the cashflow. If the loan is variable (common in UK and interest rates rise (likely)), or if rents drop, then the excess cashflow totally disappears and you find yourself with a negative cashflow hole every month to cover.

In conclusion – look for the ‘sweet spot’ in gearing – where your cashflow is not at risk but use the banks money to maximise your own returns.
Photo: Flickr

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