by Gnifrus Urquart
Leverage is a term used in investment circles to explain a type of borrowing. Its investment jargon, so it may sound complex. Its simply describes the process of borrowing to invest, where there is some kind of security underpinning the borrowing. This could be a house in a property loan, or stocks in a margin loan.
This article is all about the risks and rewards of borrowing to invest, or leveraging investment strategies. The information is general in nature and not intended as specific advice. As always, if you intend borrowing to invest, seek licensed financial advice before you do.
Before I understood money, my debt profile looked very similar to most peoples. I had a credit card which I always struggled to get back to zero, I had a large personal loan for a car I bought and a smaller loan for some furniture.
All these debts were used to fund consumables – objects for my pleasure. I learned that there are two issues with this. Firstly, the objects this debt bought all rapidly lost value. They were depreciating assets. Secondly, as I used the debt to purchase things I consumed, the interest on that debt had no tax benefits. I had to pay it all.
Today, due to the many benefits I found you get when you borrowing to invest, my debt profile is anything but typical. I now have much more debt, but I have borrowed to buy appreciating and income generating assets. For example, I have a massive debt on a property in Victoria, Australia. I also have a reasonable size margin loan helping me make money in a successful stock trading strategy. And finally, as per all foreign exchange trading accounts, I have an account which is leveraged out (and heavily too, at 400:1 – so every $1 I put in allows me to invest $400). My debt on consumables on the other hand is negligible.
What is the logic then of borrowing to invest?
When you borrow to invest, you increase your investment earnings potential. As you borrow money, you have more to invest. Therefore, the returns on your investments increase by the net returns on the borrowed money. Obviously the basic key here is to ensure your investment return rate is higher than the interest rates on the loan. If this is the case, you will always make money with the money you have borrowed.
Generally speaking also, interest payments on investment borrowing are tax deductible (get advice from your accountant on this point). As the borrowings have been made to increase your income, the interest payments on the loans are a direct cost of your income production. This typically makes the interest payments a tax deduction. For example, as my investment property creates a rental income, the borrowing are a cost associated with producing that rental income.
Margin loans work in exactly the same way. I have some stocks and I borrow some money using them as collateral. I typically try and keep a 50% leverage ratio, every dollar of stocks I own lets me borrow and invest another dollar. So I end up with a stock portfolio double the size I could have bought with my own money, I earn the returns on the entire portfolio, but pay interest on the money I have borrowed. Because I borrowed to earn money on stocks, the interest is tax deductible for me.
So there is definitely an argument for borrowing to invest where you can, instead of borrowing to fund personal purchases. There are risks associated with leverage too though you need to be aware of.
So what are the risks associated with borrowing for investment purposes? One of the obvious risks relates to your financial capacity. There is the risk you over-extend yourself and cannot meet the repayment obligations on your loans. When taking out a loan, you need to be sure you can pay the loan repayments.
Margin loans are a little bit different. They are set up so you are allowed to borrow a certain proportion of the value of the stocks held in the margin loan. The risk here is that if the value of your stock decreases rapidly and pushes your margin loan outside those boundaries, you will receive a margin call. The margin call will force you to repay a significant part of your margin loan debt, to ensure it is again within the stipulated proportion of your stock values. This can often be difficult as it requires you to fund the debt when you had not budgeted money to do so.
There is alway also the possibility that your trading strategy loses money. If this happens, because you borrowed so you could invest more, you lose more money.
One of the reasons its important to speak to a licensed financial adviser is that these risk can be managed properly with the correct strategy. This will make managing your risk much easier and making money on you borrowing much easier. With the right strategy, leveraging your investments can be extremely beneficial.
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