This article on gearing is by Planalyst from Team Monevator. Every Monday brings more fresh perspectives from the Team.
Borrowing to invest – or ‘gearing’, as seasoned investors call it – is as simple as it sounds to get started.
You take out a loan. Then you invest it as you would your own capital for potential growth.
However the journey and outcome you’ll get from gearing is much more complicated and uncertain from there.
What a difference a decade makes
The Investor explained in a mini-series a decade ago why borrowing to invest is usually a bad idea.
Just as he was writing coming out of a recession, so I am with this article.
Gearing is common practice for businesses, investment trusts, and fund managers. And it has been steadily increasing to the point that margin debt – gearing directly applied to an investment portfolio – is at its highest level in the US for more than 10 years.
But a big difference between now and back then when a younger, better-looking Investor was sharing his thoughts is that personal loan interest rates are much lower today.
Best Buy personal loan rates are below 3% APR. That’s a far cry from the 10% The Investor talked about in the aftermath of the financial crisis.
Still, with the post-pandemic economy recovery we’re already hearing talk of central banks pushing up base rates to combat higher inflation.
Does that make it a good time to gear up your portfolio by fixing a low interest rate loan for long-term investment?
The good, the bad, and the gearing
I recently explained gearing to Mr Planalyst. He wondered why I didn’t use gearing for my investments to try to ratchet my returns even higher?
Particularly, he noted, because my investments have made an average 11% return a year. (Thank you, bull market!)
Mr Planalyst saw it in simple terms. Why not use someone else’s money to make us more money?
So we sat down to planalyse this idea. And I created the tables below to explore the following ‘what if’ scenario.
Say we borrowed £30,000 to invest, at a 3% annual interest rate over a 10-year term.
For simplicity, we’ll assume the compounded debt interest is rolled up to be repaid at the end of the term, with the original capital. (Personal loans are usually repaid over time, but this makes the maths very complicated).
A calculator tells us that this borrowing and interest totals £40,317.
We’ll also assume the borrowing is all invested in a single passive tracker fund. And we’ll model returns according to two example scenarios.
Gearing scenario 1: good times
The UK market tends to see at least one steep decline every ten years or so. Typically stocks will fall 20% or more during these drawdowns.
Our first table therefore shows the potential position of a borrowed £30,000 after ten years that suffers one such crash. (All numbers rounded to the nearest pound.)
In this (fictitious!) example we see an average annual return of around 4% overall. But there’s a fall of -20% in one grim year halfway through:
| Year | Portfolio value | Annual return % | Annual return £ |
| 1 | £30,000 | 9% | £2,700 |
| 2 | £32,700 | 8% | £2,616 |
| 3 | £35,316 | 9% | £3,178 |
| 4 | £38,494 | 7% | £2,695 |
| 5 | £41,189 | -20% | -£8,238 |
| 6 | £32,951 | 2% | £659 |
| 7 | £33,610 | 4% | £1,344 |
| 8 | £34,955 | 5% | £1,748 |
| 9 | £36,702 | 7% | £2,569 |
| 10 | £39,272 | 9% | £3,534 |
| End total / average return | £42,806 | 4% |
In this first scenario, using gearing worked out positively – although the end result was only a little ahead of the cost of borrowing (£40,317).
Remember: market volatility means you can’t guarantee any returns.
There’s no certainty of a gain at the end of the borrowing period to repay the debt and the interest accrued. Never mind enough to deliver a profit for going to all this trouble in the first place!
Even if you come good in the end, seeing your total invested assets that you bought with gearing go below the amount at stake during the term won’t be easy. It could be emotionally upsetting.
Obviously it’ll be even worse if you come up short at the end of the term.
Talking of which…
Gearing scenario 2: bad times
In this scenario our returns are almost as before – except for the last two years.
This time the market’s recovery from its decline is very sluggish, rather than it bouncing back to pre-downturn levels as in the first scenario.
And again, after ten years your term is up and your debt must be repaid:
| Year | Portfolio value | Annual return % | Annual return £ |
| 1 | £30,000 | 9% | £2,700 |
| 2 | £32,700 | 8% | £2,616 |
| 3 | £35,316 | 9% | £3,178 |
| 4 | £38,494 | 7% | £2,695 |
| 5 | £41,189 | -20% | -£8,238 |
| 6 | £32,951 | 2% | £659 |
| 7 | £33,610 | 4% | £1,344 |
| 8 | £34,955 | 5% | £1,748 |
| 9 | £36,702 | 4% | £1,468 |
| 10 | £38,171 | 2% | £763 |
| End total / average return | £38,934 | 3% |
After ten years you don’t have enough to repay the loan plus its interest – £40,317 – let alone seen a profit.
This example demonstrates the risk of having to sell when your capital is down to repay your debt. You are forced to realize a loss.
You might have fretted about this outcome for half the loan term – from year six onward. And the risk would have come true.
Maybe you’ll have greyer hair, too.
Debts must be repaid. You would have to dip into other savings or income to repay the bank what you owe. Assuming that was even an option for you.
Outcome
Here’s how the numbers work out from these two scenarios after ten years:
| Scenario | Debt and interest | Portfolio | Balance |
| 1 | £40,317 | £42,806 | £2,489 |
| 2 | £40,317 | £38,934 | -£1,384 |
In the second example, we see how interest – the cost of debt – has amplified the losses compared to just investing £30,000 of your own money.
Of course you might see far higher average annual gains than 3% or 4% over ten years. That would make borrowing to invest very lucrative.
But you could also see lower returns, too.
This unpredictability of future market moves is why I wouldn’t consider gearing to invest. The risk of volatility and market falls at the worst time are too great to ignore – even for that chance to make a healthy profit.
Historically, stock market returns have been far higher than today’s low cost of debt, which might make the odds seem pretty good.
But personally I don’t have the stomach for it.
Gearing up for a fall
You say you’re willing to accept the market’s ups and downs? There are other factors and caveats to consider before you gear up.
More risks to think about
In the above examples, I kept the structure of the loan very simple.
You could use monthly or annual interest repayments instead to take the pain away from repaying a lump sum at the end. The exact loan structure chosen upfront could even make or break the eventual returns. This adds extra risk – it could turn out to be wrong for your future circumstances.
With such an arrangement you’d also need to keep up regular repayments, adding to your household expenditure. This would reduce your disposable income for any other investment opportunities that may arise over the fixed term of the loan.
In the event of a market crash – perhaps with a recession – having to make regular repayments could prove tough if you faced job insecurity.
And don’t forget investment costs along the way. These haven’t been explicitly broken out in my examples above. They will eat into any growth.
You may also have taxes to pay on your gains when it comes time to repay, though this depends on how you invest.
Investing in an ISA can take away the tax pain, as a Monevator article by Finumus recently stressed.
Risk reducers
You might be attracted to variable interest rates loans, particularly if they start off lower than a fixed rate option.
But variable rates add extra interest rate risk. Locking in a fixed rate now makes future budgeting certain, even if your investment returns are not.
Taking out a long-term loan for investment can soften the blow of short-term market volatility. Investing is a long-term game. Securing returns is more about time in the market than trying to time the market.
In contrast, you’re likely to risk making even greater losses by gambling to chase returns to repay a debt over a short timescale.
This is why The Investor suggested in his series that a mortgage is the only debt that’s prudent for most people to consider while also investing in risky assets like shares.
Finally, you may choose to diversify across different asset classes and funds, rather than rely on one tracker.
Properly diversified investments would mitigate the downside risk, at least to some extent, but it could also curb your expected returns.
Changing gear
Even if gearing is not for you when it comes to your portfolio, knowledge of how it works might still prove useful.
Case in point: there exists a financial calculation called the gearing ratio, which analysts use when assessing companies.
Companies typically take out debt to invest in their own businesses.
The gearing ratio is a company’s total debt divided by its total equity.
If the gearing ratio is:
- Over 50% – The company is highly geared, so future downturns and high interest rates could put the company in trouble.
- 25%-50% – Considered normal for most large companies.
- Under 25% – Probably a lower-risk investment, but potentially also a slower growing business
Gearing ratios need to be considered in the context of a company’s sector/specific industry.
For example, utility companies have strong recurring cash flows. Their higher levels of gearing might therefore be considered less risky than for instance a manufacturer borrowing to build a factory.
Gear for you
The gearing ratio might also be applied to your personal finances.
The ratio could give clues as to how much debt a household could comfortably carry before things get risky. Not only when taking out a loan for investing, but also when deciding to take on a mortgage or car loan.
To work out your personal gearing ratio, you’d divide the total level of actual or proposed debt by your total net assets.
Note: as far as I know there are no hard-and-fast rules here.
If we took the thresholds I gave for companies, for example, then having more than 50% of your personal assets in debt would seem very unwise.
However, this is typically what happens when buying a house, with today’s high prices. Many young buyers have very little elsewhere in the way of assets after scraping together the deposit for a 90% loan-to-value mortgage.
At least your home’s value won’t fluctuate like the stock market. (Which is exactly why borrowing to invest in a house is a mainstream activity.)
Reverse gear
If you’re thinking of gearing to invest, do your homework and thoroughly consider all the costs and the additional risks.
Some sophisticated investors could make it work for them.
But for a typical individual, gearing explicitly to invest in the stock market is not a risk worth taking. Better to get rich slowly!
See all Planalyst’s articles in her dedicated archive.
Comments on this entry are closed.
So say we borrow 30K. Stick it in a SIPP. So the government gives us
20%
How would that affect the maths?
Personally, I would use gearing in a different way. Instead of borrowing 100% of capital and invest it, I would only borrow up to 50%, i.e.: 50% my own + 50% borrowed money.
To illustrate the concept, consider your scenarios again, but with only 50% borrowed money, which means you invest £15,000 your own money + £15,000 borrowed money for 10 years. Using the same compound interest calculator, I know the interest and principal repayable is £20,158 in total at the end of the 10 years. Now let’s look at the two scenarios again:
* The good times scenario
You will grow your £15,000 to £22,648 after fully repaying the loan. That’s roughly 50% return on investment, or 4.21 % annually. (Comparing to 4% annually if you hadn’t borrowed)
* The bad times scenario
You will grow your £15,000 to £18,776. That’s roughly 25% return on investment. The CAGR is 2.27%, instead of the 3% you would have got if you hadn’t borrowed. It is lower because you had to pay the cost of borrowing, but you are not in the red, and you can simply borrow £18,776 and invest the whole sum for another 10 years if the interest rate is still favourable. Don’t forget that the market average return over a longer term is much better than the 3% you’ve just had.
@Erico1875
You can’t access a SIPP until retirement, so if you do that you best be sure you can pay the loan down! What if you lose your job?
@ Erico1875
And don’t forget you pay tax on withdrawal on your SIPP, so the tax advantage is actually wiped out. For most it would make more sense to use leverage within your ISA.
My personal view is nobody can predict the future, not even those supposedly with access to primary information on markets. 100% gearing in personal investments I would and still avoid.
I have looked on my own at the above example for buying Emerging market Bonds (USD denominated and other corp bonds as opportunity to invest whilst pay back the principle over 5 years with my income from job as it is about 4% yield atm.
As always I come back to the what if something goes wrong and you are left with a monthly commitment and you had to sell them at a loss?
Margin debt is at an all time high in the US with folks trying to do just this, eventually it will have to be unwound..
https://www.forbes.com/sites/greatspeculations/2021/04/24/uh-oh-market-leverage-at-all-time-high/
This isn’t really applicable if you’re taking out a personal loan for investing (as it will likely have a negative carry), but there’s a good case for levering up the diversifying assets within your portfolio to increase returns whilst decreasing the risk.
https://earlyretirementnow.com/2016/07/20/lower-risk-through-leverage/
n.b. this example is illustrated with futures contracts rather than a personal loan.
A simple form of indirect gearing is to not prepay the mortgage and also extend it to the original term every time you re-mortgage.
I’ll be extending it to 30 or 35 years (if the 35Y rates aren’t too high) every time I re-mortgage, if banks allow.
Effectively borrowing at the mortgage rate long term, but only if I have the discipline for I invest it wisely.
@Andrew.
I was thinking along the lines of remortgaging one of my BTL properties. Nothing crazy, maybe 65% LTV.
The rent is about 3.5 times the interest payments, so easily affordable.
Im old enough to draw a pension if I want to.
It was the compounded effect of the extra 20% that intrigued me, and of course in time we could take 25% tax free
Margin loans cost 0.75% at IB. The 3% personal loan rate is wildly inappropriate.
People with 100% equity portfolios should ask themselves what the odds are that 100% is the perfect level of risk? Why not 110% (gear up) or 90% (hold some cash/bonds)?
I’m rather bemused that this post demonstrating why gearing is not a great idea, is followed by lots of comments by posters, who seem to think it is.
@BuildBackBetter – I did exactly the opposite, every time I remortgaged I reduced the term if the rate was better or increased my contributions, if I could afford it because of salary rise. This approach meant I paid off my mortgage in approx. 13 years, saving me Having cleared the debt I then increased my savings rate, with the extra income.
I wouldn’t even touch borrowing to invest with a barge pole.
Inflation is coming… make that 2 barge poles.
@Whettam (#10)
Your approach sounds familiar – no regrets yet hereabouts!
@Alex – bit presumably your 50% would have been invested anyway? So the figures are 50% of those presented. Exactly the same but you might have wiped out all the gains on your own money. Alternatively, if your money wouldn’t have been invested, there’s an opportunity cost of other (possible!) returns foregone to account for.
No such thing as a free lunch…
@Whettam, Al Cam – yep, us too. And no regrets about ‘missed’ gains. My family is safe including 1929, the 60s, 2000, etc, etc.
@Ben. Very sensible comment. I always find it odd that people seem to think that 100% invested is somehow correct but that 200% is always risky but 50% is too risk averse.
@Ben — Very much take your (and @ZXSpectrum’s) point, but of course a marked-to-market margin loan is a different risk proposition to personal loan, too.
Erico1875 – with your suggestion on borrowing to add to a SIPP and getting the tax uplift, it could work to enhance returns/limit downside if you can match your timeline of being able to access it when the loan is due (and not have to pay interest during the loan). You’d also be limited on how much loan you could put in to your annual income if you are a basic rate payer or the £3600/basic SIPP allowance.
However, you’d then be using your tax free withdrawal (currently 25% of pot up to lifetime allowance) to repay the loan rather than having it available to spend/invest elsewhere (such as an ISA).
@BuildBackBetter yes, this is what I do too. As long as mortgage rates remain at 2%, overpaying isn’t an attractive way for building net wealth. There have been some related articles on monevator about using interest only mortgages which is a similar concept
A long time ago, when all my friends were freely borrowing money from their overly generous banks to purchase scrap metal (the gas guzzling varieties as opposed to the precious periodic table ones that might actually generate a return), i asked my high street bank for a loan in order that i might invest in an upcoming floatation that i thought might do rather well, one Abbey National Building Society. My bank in their wisdom took one look at me and offered a tiny fraction of my request, to which i honourably declined and that was that. Their decision cost me a small fortune as the shares rocketed (circa ten-fold if my memory serves me right) over the next few years.
Lesson learned, from that day on i resolved to never enter into any unnecessary dealings with any bank, a decision which has quite possibly more than repaid my lost investment opportunity. Thankfully the figures are now irrelevant but i will never forget this financial education.
I have no need to borrow from a bank these days and have no idea how they might respond to an application to speculate on the stock market, but back in my day i recall all my friends urging me to tell the bank that my loan request was for a ‘car’, and that i’d be pretty much guaranteed to get the cash on that basis. My youthful self had thought honesty the best policy and even assumed that a clever bank would share my conviction that the floatation was a grand opportunity.
Now, i do just wonder how much my younger self could secure today from the institutions, were I to hypothetically request a loan to ‘invest’ in for example a crypto currency. Thankfully i will never know the answer.
@Ben IBKR rate floor is 0.75% but blended rate closer to 1% for £1m and as much as 1.5% on lower balances.
I have been looking into margin loans for a while now and am close to pulling the trigger on a 30% ltv facility against a USD portfolio. It’s definitely not for everyone. I personally think 100% equities (no leverage) is entirely different from 101% or any % leveraged investment, a “phase change” much like the difference between ice and water or a mortgage vs mortgage free, freehold property.
Not absolutely on topic but I’ve just changed 70/30 to 60/40 for equities/bonds.
This is mostly motivated by the tax limiting upside to possible pension growth above the lifetime allowance.
While I can grasp the possibilities of leverage, and running any type of risk assets whilst you possess any type of debt is leverage. What I have never been comfortable with is the fact it can send you backward faster than it can push you forward due to the drag of loan interest.
When I first took out a mortgage, most mortgages were mainly interest only, endowment backed. Effectively a leveraged product – but endorsed and sold widely by “financial professionals”. The fees were steep over the lifetime of the product and after a few years we can all see what happened to them in our financial history books. I have never claimed for mis-selling those products, one matured with a £200 shortfall and the other is on target for a small surplus next May – they worked out fine in the end! (And inflation has made shortfall or surplus mainly irrelevant)
My risk tolerance is now diminished, I don’t need or want leverage. If I was to give my younger self a good talking to (I wouldn’t have listened) perhaps I would have taken more risk, as it turned out – I didn’t need to.
Horses for courses.
“Temet Nosce”
JimJim
@Brod (#13)
Yes, of course. My own money and borrowed money are together treated as two parts of a single portfolio and will be invested in the same way. However, you should not think about the portfolio as two parts and each part is responsible for its own profit/loss, the same reason that you don’t think each part in a 40/60 equity/bond portfolio in that way. This is one portfolio, and at the end it’s the profit/loss of the whole portfolio matters to the investor, not each individual components of it.
After investing borrowed money in the stock market for five not-so-good years, you may underperform the market due to the cost of interest, but that doesn’t change the fact that the decision to invest cheap borrowed money was a good decision at the time it was made. We all know the historical long term average stock market return is higher than the 3% interest rate, and it’s highly likely continuously to be. Therefore anyone borrowing at 3% interest rate for rolling 5+ years to invest will likely to outperform the market in the longer term. To remain solvent and avoid being wiped out in a bear market right before it’s time to repay your loan, borrowing up to 50% of the portfolio (i.e. 100% of your own money), and roll the loan over at approximately one year before it’s repayment date. The borrowing limit and early roll over rules exist because the market very rarely go down by 50% or more. and you will be wiped out if you cannot roll the loan over when the market is down by nearly 50% and are forced to sell in order to repay the loan.
I’m not suggesting borrowing to invest is suitable for everyone, but it certainly is practical and is available for investors with higher risk tolerance. I had done it in the past, and have stopped doing it only because my personal financial situation had changed (I spent most of the capital I invested for a big purchase). I will consider leveraged investments again in the future once I have enough capital to justify the extra admin work involved.
@ Alex – yes, of course it is one single portfolio. But you have also introduced onto your portfolio balance sheet not only a liability equal to the loan plus interest (a negative bond, as it were), but also sequence of returns risk in your accumulation phase – you’re now at the mercy of having a favourable pattern of returns.
Good luck!
I think @TI said it all 12 years ago and nothing has really changed. Borrowing rates might be lower, but future returns are likely lower too.
The profit from borrowing to invest is proportional to the difference in performance between the portfolio purchased and the borrowing costs. But the crucial thing with borrowing is that the profit is contingent on the borrowing requirements being met throughout the investment period, as rightly pointed out in the article. It is this extra risk that is often missed, or underestimated by those considering borrowing to invest.
Using a margin account is even more risky as you have to be continuously able to meet a margin call, even when on holiday when you might have better things to do than monitor markets, etc. In addition to the market risk, the broker can change their margin requirements at the drop of a hat. Broker offering up to 50% margin on your portfolio? Sounds good until the broker decides the market is very risky and increases the haircut on your colateral.
Borrowing/margin introduces a path dependency risk into your return. This path dependency risk does not exist at all with portfolios up to 100% equities.
Borrowing to invest in a pension is different and if done with care is capable of delivering risk free returns (almost risk free). For example, borrow £4000 and pay it into a SIPP and leave as cash. As soon as possible, crystallise £16k of the fund, taking the £4000 as tax free cash, then pay off the loan. £1000 tax relief eventually turns up in the SIPP from HMRC. A couple of months interest on £4000 puts £1000 in the SIPP and for higher rate taxpayers, another £1000 tax relief back into your bank account from HMRC. This will work with any amount up to the pension annual allowance, but be careful if crystallising more than £30k per year that you do not get caught by the pension recycling rules. The recycling rules are not particularly onerous and easily avoided, but definitely something to be aware of.
To reduce risk it is best to be over 55 to perform this trick, so that the SIPP can be crystallised at any time and the loan repaid.
@Naeclue (#24):
Re the SIPP tax relief wheeze, a couple of minor questions/points:
a) “This will work with any amount up to the pension annual allowance” IIRC this is only true if, and only if, you have not made any drawdowns; otherwise it is usually limited to the money purchase annual allowance; and
b) are there still any SIPPs that pay interest on cash and charge no fees on cash holdings?
@Al Cam, I just checked Hargreaves Lansdown and they don’t charge a fee for holding cash in their SIPP. They are not paying interest on cash at present.
Agree about not drawing from the drawdown fund. Taking 25% pension commencement lump sums does not restrict future pension contributions, but taking money from the drawdown fund does.
Here is a useful link on the pension recycling rules: https://www.pruadviser.co.uk/knowledge-literature/knowledge-library/pensions-recycling/
@BeardyBillionaireBloke
“Not absolutely on topic but I’ve just changed 70/30 to 60/40 for equities/bonds.
This is mostly motivated by the tax limiting upside to possible pension growth above the lifetime allowance.”
You do know that there is no “tax limiting upside to possible pension growth”? Exceeding the LTA (at a crystallisation event) will mean a loss of 25% of the excess growth. In other words your SIPP still gets to keep 75% of the amount you are over. I can understand going for a safer asset allocation if you lost 100% of the excess amount, but this sounds a bit like turning down a pay rise because it would mean paying tax at 40% instead of 20%.
I’m very interested to hear more knowledgable discussion and dissection of the ideas in the ERN article that JP linked to in post #6 of these comments. In the article Big ERN talks about using bond futures contracts to leverage up the bond portion of your portfolio. He claims that this reduces overall portfolio risk while maintaining expected returns for a given equity allocation. The article shows how bond leverage does this by modifying the efficient frontier. I am no expert, so I may be missing something major, but ERN’s arguments in favour of bond leverage certainly *seem* persuasive— it seems like a free lunch! But then why isn’t everyone doing it!? I know nothing about futures contracts or how it might work for a UK investor. Can someone knowledgable chime in?