WHAT IS GEARING?
The easiest way to understand financial gearing
is to think about it in the same terms as a mortgage.
If you buy a house for £250,000 and pay
a £25,000 deposit, you borrow £225,000.
Five years later you will have repaid about
£31,000 in capital and paid about £59,000 in interest.
If you then sell the house for £500,000
your profit is £500,000 less £219,000 to repay the mortgage,
less £59,000 paid in interest, less £25,000 deposit.
This leaves a profit of £197,000.
So for a £25,000 investment, you have received
a near-700 per cent return, despite the fact that the property
rose in value only by 100 per cent.
That is gearing. When you borrowed £225,000
against your £25,000 you were nine times geared. This represents
much higher levels of gearing than virtually all investment trusts.
But gearing is a double edged sword.
If the property were to fall in value and you
needed to sell at £225,000, you would lose all your deposit
as well as having paid interest all those years.
Thus a mere 10 per cent fall in the value of
the property is sufficient to wipe out the initial investment.
That too is the nature of gearing.