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Select Committee on Treasury Minutes of Evidence

Annex B


  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.

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Prepared 17 October 2002