Case studies

Investing to build wealth over time

Instalment Gearing

Jillian wants to invest in an approved Australian share fund on a regular basis over the next ten years. After consulting with a financial adviser, she is considering the following options:

1. Investing $1,000 per month from her regular income in addition to an initial lump sum of $5,000 (a total investment of $125,000 over a ten year period).
2. Using an instalment gearing strategy, initially investing $10,000 (ie $5,000 of her money plus $5,000 in borrowed money), followed by monthly investments of $2,000 (ie $1,000 per month of her money, together with $1,000 per month of borrowed money).
   Over ten years, the total amount invested will be $250,000 (ie $125,000 of her money, plus $125,000 of borrowed money). Her investments will therefore be 50% geared.

The graph below illustrates the potential outcome of these two options after ten years.

Assumptions:

Ten year investment period.  The managed fund has a security ratio of 60%.  Investment return is 8.5% p.a. (split 3% income and 5.5% growth).  The franking level on income is 75%.  Interest on the loan is 8.0% p.a.  Jillian's marginal tax rate is 41.5% including a Medicare Levy of 1.5%.  Where investment income and tax benefits are insufficient to meet interest payments, a portion of the investment is sold to cover the shortfall.  Otherwise the excess investment income and tax savings are reinvested.

If Jillian decides to pay back the $125,000 loan in Option 2 at the end of ten years by selling units in the Australian share fund to repay the loan (and pay capital gains tax on the amount withdrawn), the value of her investment is shown in the table below.

Value of investment after repayment of loan

* After CGT on the amount withdrawn.

When compared to the 'no gearing' scenario, instalment gearing has clearly made a significant difference to Jillian's financial position.

Accelerating towards your financial goals

Lump Sum Gearing

Jack already has $50,000 invested in an approved Australian share fund (with a security ratio of 70%). After speaking to his adviser, he is considering three options:

1. Maintaining his investment at $50,000
2. Doubling his investment by borrowing $50,000 through a margin lending facility (a 50% gearing strategy)
3. Increasing his investment even more by borrowing $100,000 through a margin lending facility (a 67% gearing strategy).

The graph below illustrates the potential outcome of these three options after ten years.

Assumptions:

Ten year investment period.  Investment return is 8.5% p.a. (split 3% income and 5.5% growth).  The franking level on income is 75%.  Interest on the loan is 8.0% p.a.  Jack's marginal tax rate is 41.5% including a Medicare Levy of 1.5%.  Where investment income and tax benefits are insufficient to meet interest payments, a portion of the investment is sold to cover the shortfall.  Otherwise the excess investment income and tax savings are reinvested.

As you can see from the graph, the higher the gearing level the greater the potential returns. It must be remembered, however, that Jack still has an outstanding loan in options 2 and 3 of $50,000 and $100,000 respectively. If Jack withdrew a portion of his investment after ten years to repay the outstanding debt (and pay capital gains tax on the amount withdrawn), the value of his investment is shown in the table below.

Value of investment after repayment of loan

* After CGT on the amount withdrawn

Clearly, margin lending has the potential to help Jack achieve his goals, so long as the value of his investments rises sufficiently.