Recent publicity about the plight of hundreds of managed investment scheme investors faced with losing their houses to pay off debts provides a timely warning to all geared investors. No matter how good an investment may seem, especially if it offers large tax savings, it's still essential to be aware of key investment fundamentals. These include that investment outcomes are never certain and borrowing to fund an investment increases the risks of loss.
The fact that lenders may be keen to fund the purchase doesn't guarantee they have investigated the quality and merits of the investment. The lenders' main concern is the quality and value of the collateral provided, as well as the capacity of the borrower to service the loan.
If the lender is prepared to fund the project without personal guarantees or requiring the family home as collateral, this can be a positive sign about the quality of the investment. However, few loans are offered on a non-recourse basis, leaving the personal assets of the investor free of any risk of loss. Lenders operate to minimise their risks of loss, which explains why investors, especially those with substantial equity in their home, are key targets for purveyors of higher-risk investments, particularly those offering tax advantages.
Former Columbia University law professor George Cooper explained the popularity of tax shelters by referring to how the minds of otherwise rational people turn to mush when offered the prospect of not paying any tax, especially when only small
initial cash payments are required. Small or no cash outlays can lead to investors putting all their eggs in one basket because of the large loan component.
Although it may require effort and research, understanding the risks involved with investments and diversifying a portfolio can help avoid disaster. The fact that an investment is being marketed aggressively is a warning sign to be cautious.
The current speculation that the rules governing access to borrowing by investors will be tightened does little to change the fundamental situation. Investors are easier targets for snake oil merchants because of the capital they can offer as collateral.
Increasing borrowing costs for investors as is currently being suggested will also do little to cool the property boom, unless, of course, that involves reducing the advantages of negative gearing. While it's cold comfort to investors who have lost or stand to lose their houses from gearing into managed investment schemes, the reality is that the main reason many of them geared up so heavily was the large tax savings offered by the government.