The gearing ratio

You do not have to borrow 75%.

Instead you could choose to invest $25,000 and combine it with borrowed money of $25,000 giving you a $50,000 investment.

Your investment would then be made up with 50% of borrowings.

To compare gearing strategies you can use a gearing ratio or a loan to valuation ratio (LVR).

The gearing ratio is calculated by dividing the borrowed funds by the investor’s contribution. Using the above two examples the gearing ratios would be:

Gearing ratio 1 = $75,000 / $25,000 = 3 times

Gearing ratio 2 = $25,000 / $25,000 = 1 time

The gearing ratio shows that the first example has a much larger gearing ratio with 3 times as much borrowings. The higher the gearing ratio, the higher the potential risk.