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Gearing means borrowing money to buy an asset. There are three types of gearing: negative, neutral, and positive.
Table of Contents
What is negative gearing?
Negative gearing is when you borrow money to invest in an asset (usually a property) and the income you make from that investment (rent).
The idea is to buy properties to rent out to tenants and don’t expect to make money on the rent. Instead, they purchase the properties intending to cash in on a property’s long term capital growth.
The goal of this type of gearing is so that real estate investors can limit their losses until the time comes to sell. Primarily, negative gearing works if the money an investor makes from a property’s capital growth is greater than the loss they make from the rental shortfall.
What is neutral gearing?
Neutral gearing is when an investor borrows money to invest in an asset, and the income you make from that investment is equal to your expenses. This means that you are breaking even on your investment and cannot deduct any losses from your taxable income.
What is positive gearing?
Positive gearing is when you borrow money to invest in an asset, and the income you make from that investment is more than your expenses.
However, you could use your surplus income to reduce the size of your loan.
Of course, positive gearing is the best option for investors, but high competition among landlords means that it’s not always possible to increase rents to a level that allows them to earn a constant income on their investment.
Case Study
Let’s say an investor buys a property for $440,000 and takes out a $400,000 loan at an interest rate of 7%. The annual interest payable on the loan is $28,000.
The investor charges $430 per week in rent, which adds up to an annual rental income of $22,360.
Based on the figures above, the investor is paying $28,000 in interest but only earning $22,360 in rent, which means they have a rental a shortfall of $5,640 per year.
This means that they are making a loss, and their property is ‘negatively geared.’
The importance of capital growth
A year later, the property’s value goes up by 10%. The property is now worth $484,000.
And so, at the end of one year, the investor has paid out $5,640 in interest, but seen their property’s value increase by $44,000. This means that, even though the investor paid more on interest than they received in rent, they are theoretically $38,360 richer than they were 12 months ago, as the total value of their assets has increased.
That said, when an investor does eventually sell their property, the capital gain they make on the sale – defined as the difference between what they paid for the property (less any fees incurred during the purchase) and what they sold it for (less any fees incurred during the sale)
In short, negative gearing will make you money if the property’s long-term capital growth is greater than the loss you make in rental shortfall.
What you need for negative gearing to work?
