In this article, I discuss some of the considerations when thinking about borrowing money to invest in shares. This is a very high risk strategy as borrowings adds leverage which magnifying returns, both positive and negative.  Only investors with a high risk tolerance and long-term investment horizon should consider this strategy and even so, I am usually reluctant to advise people to borrow money to invest in stocks, unless they have a strong desire to do so.

Where we do implement a gearing strategy, there is usually a bias towards high dividend stocks that help cover interest costs on the borrowed money.  For example, if someone borrows $50,000 to invest in stocks at 6.5% interest, that is $3,250 per year in interest.  If the $50,000 is used to purchase high dividend stocks such as the bank stocks, the investor will get a grossed up dividend of approximately 10% (based on current share prices and dividend levels) or $5,000.  Therefore the dividends will help alleviate the interest burden and if share prices fall, at least a large part of the interest cost on the loan can be met by the dividends.

Below are my comments in the article:

“PSK Financial Services adviser James Gerrard says having made the decision to invest, some of the factors to take into account are the source of funds and cost of capital as well as how much to invest.”

“Gerrard says while a margin loan carries with it the risk of a margin call if a share price drops below a critical loan to valuation level, there is no such issue with a line of credit.

Where investors do have to be careful is if companies stop paying or cut dividends which will reduce the ability to pay down the interest costs or if interest rates rise and there is a funding shortfall.

Gerrard says investors using a line of credit should factor in a 2?percentage point interest rate buffer.

Gearing can magnify both positive and negative returns.”

“If a shareholder is on the highest marginal rate, they will be taxed on fully franked dividends at a rate equal to the difference between the company tax rate (30?per cent) and their marginal tax rate. A shareholder on a low marginal tax rate will receive the franking credit attached to the dividend,” says Gerrard.”

Below is a link to the full article:

Borrow to invest and win over long term – BRW (Bina Brown – 5 September 2012)