Just as important as picking the right property to invest in, is choosing the most appropriate strategy to go with that investment.
Today, we talk about two types of investment strategy – positive and negative gearing; what they mean and the pros and cons of each.
Positive Gearing is an investment strategy wherein you borrow money to invest and the income you gain from that investment is greater than your interest and expenses. This means, you will receive money from your investment on a regular basis and act as a passive income.
Increased Income – the main benefit of positively geared properties is that you receive income from the property from day one. This is extremely helpful as you can use the extra revenue to make additional payments into your mortgage and be able to claim ownership of it in less time.
Fewer Risks – In an event that your financial situation changes, the extra income you get from your investment property can cover the costs and other expenses along with it. This enables you to utilise your investment and continue to earn money from it.
Taxable – The additional income you get will move you into a higher tax bracket, which in turn, will inevitably subject you to pay more tax.
Slower long-term growth – Though not always the case, a positive cash flow investment located in regional areas commonly involve slower capital growth due to lower population and employment demand.
Negative Gearing is an investment strategy wherein you borrow money to invest and the income from that investment is less than the expenses. In other words, you are making a loss. With this in mind, you will probably need another source of income to fully cover the expenses related to the property.
Tax Deductions – A common reason why investors apply negative gearing is because of its tax minimisation strategy. It offers immediate tax advantages as cash loss is offset against other sources, reducing your taxable income.
Capital Growth – In the event that everything goes smoothly, and all goes to plan, the capital returns from the property will eventually outweigh the borrowing levels and costs. You can offset your losses with capital gain in the future when the value of the investment increases. This increase is expected to outweigh any short-term financial losses to create wealth for the investor come sale time.
Higher financial risk – This strategy obviously imposes higher financial risks especially when your financial situation changes. Just like when you lose your job, you will still need to be able to pay for any overheads involved such as insurance policies and income protection.
Cash Flow – Since this strategy is based around servicing a property generating a deficit, you won't reap the benefits until tax time and must have enough cash on hand to pay your bills and expenses until then. Mishandled cash flow causes many business to go under, and in this case managing property is your business, so take care.
Vulnerability to Market Fluctuations - Just as we wrote that one of the advantages of Negative Gearing is Capital Gains, the flip side of the coin is that if your property declines in value then you will be unable to realise the benefits of the strategy, since Negative Gearing's prime benefit is unlocking properties in high-growth areas. In other words, the strategy is almost totally dependent on Capital Gains.
In summary, positive gearing benefits investors because it prioritises attaining cash flow on a regular basis. Negative gearing examples, on the other hand, show that it focuses more on making money through future capital gains.
Though there is no definitive answer to which strategy is better, there may be some cues on which strategy is best suited for each investor:
If you are someone who is investing for a large lump sum, wishes to invest in high growth areas, is looking to purchase just a few investment properties, has a large disposable income, then it is more likely that negative gearing could be a good investment strategy for you.
If you are investing in areas with high rental yield, aiming to have financial freedom, wishing to purchase a large amount of investment properties, have little disposable income and don’t pay much tax, positive gearing is your best bet.
It all comes down to pursuing the strategy that will help you achieve your financial goals.
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