Financial planning is really about… considering positive gearing

Positive gearing is the opposite of negative gearing. It is jargon for borrowing to buy an investment where the expected assessable income is more than the expected deductible interest cost (and other costs), with a resultant increase in assessable income.

In the context of housing prices, this means buying on a rental yield of at least 6% or more, and this is a very unusual phenomenon.

Most houses do not generate rents of more than about 3% or maybe 4% of the cost or value of the property. This means it’s very hard to positively gear houses, especially in the years immediately following a purchase.

Sometimes positive gearing works OK, but it’s usually a sign that the house has a relatively low value. This either means that the house is not that good or it needs a lot of work or such that it is falling in value and not worth buying.

Take great care if you encounter claims of positively geared houses.

Positive gearing of other types of investments is a different proposition. For example, in early 2008 we recommended clients borrow to buy bank shares, which at the time were selling on after tax yields of as much as 13%. This mean if a client borrowed say $100,000 to buy ANZ shares, they received $13,000 of assessable income, paid $6,000 of interest and made $7,000 cash profit on the deal. Plus capital gains.

It can make a lot of sense for a young client to adopt a strategy like this as an alternative to buying a home. But remember: they need to do it to the tune of at least $400,000 before it becomes a comparable strategy.

Here is an interesting tidbit: if the client back in 2008 had also borrowed $400,000 to buy a home the net dividends from the shares would more than cover the interest on the home loan. The client would also receive rent (or avoid paying it themselves) and would enjoy capital gains on both the home and the shares. This is an example of a hybrid strategy working to make buying a home easier in the long run – basically by making a person wealthier in the long run.

The Dover Group