Gearing

Gearing is a term used to describe the effects of borrowing in order to fund an investment. The following examples relate to property purchase, but could equally apply if you decide to borrow in order to increase the size of any other investment.

In these examples we assume in every case that you have a fixed amount of £100,000 to invest, and you have the option of borrowing in order to buy a more expensive property in the hope of greater profits.

Example 1 – non-geared (no borrowing) – 20% rise in value

Investment £100,000
Property bought for £100,000
Rises in value to £120,000
Net gain £20,000

Example 2 – geared - 20% rise in value

Investment £100,000
Borrowing £100,000
Property bought for £200,000
Rises in value to £240,000
Net gain £40,000

So the gain is multiplied because of the borrowing. Remember, though, that out of any gain you need to pay interest on the loan.

Example 3 – non-geared – 20% fall in value

Investment £100,000
Property bought for £100,000
Falls in value to £80,000
Net LOSS £20,000

Example 4 – geared - 20% fall in value

Investment £100,000
Borrowing £100,000
Property bought for £200,000
Falls in value to £160,000
Net LOSS £40,000

So the LOSS is multiplied because of the borrowing. Remember also that you need to pay interest on the loan, which is a further loss.

Example 5 – highly geared (heavy borrowing) – 30% fall in value

Investment £100,000
Borrowing £300,000
Property bought for £400,000
Falls in value to £280,000
Net LOSS £120,000

Now the property is worth only £280,000, which is insufficient to repay the loan of £300,000, AND the loan interest had to be paid.

This last example helps to illustrate clearly the possible negative effects of gearing. If a non-geared investment of £100,000 had been made, a 30% fall in value would have resulted in a loss of £30,000, but there would still be value of £70,000 remaining. By gearing, the losses were mutiplied to the extent that the entire investment of £100,000 was lost, and a debt of £20,000 plus interest remained after sale of the property.