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.
10 years ago, my borrowing habits were what I would call “typical” in today’s society. I had a credit card, which ranged between $0.00 to about $4,000.00 in debt. I had a small personal loan which I bought some furniture with and I had a larger personal loan which I financed a car purchase with.
The problems with these types of debt are two fold. To start with, the items I bought when I borrowed are all depreciating items. That is, their value decreases as they get older. The second thing is, due to the fact that I borrowed to buy things I could use personally, (as opposed to a money making use) I could not claim the interest on the borrowings for tax purposes.
My debt profile today is very different to the one I had when I started learning about money. Today I use my credit card merely as a float which I pay off each month and all my personal loans are paid off. Despite this I carry much more debt than I did back then. I have a massive debt on a rental property I purchased. I have a reasonable sized margin loan for stock trading and I have an ever growing FOREX trading account. Most of my debt now funds investments, practically no debt funds consumables.
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.
The second benefit you can get from borrowing to invest is a possible tax benefit. In my situation where I have borrowed to purchase an investment property in Victoria, as I rent out that property and earn an income from it, the interest payments on that mortgage become a cost associated with that income. As such, in my circumstance, I can claim those interest payments as a tax deduction. This means that while my asset is making me money, the tax office is actually giving me a discount on my borrowing by making it tax deductible
Margin loans work similarly. Basically I buy a bunch of stocks, fund 50% of the purchases myself and borrow the other 50% in a margin loan. This means I can double the size of my share portfolio and hopefully make a lot more money. Because I borrowed money though to buy the stocks which will make me money, the interest accrued in the margin loan is tax deductible.
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.
The first risk with borrowing to invest is the same with all loans. Loans come with obligations. You need to be able to fund the repayments, both the principle and the interest. So you need to do your sums properly and work out whether your income can cover these repayments. If you mess this up and over-extend yourself, typically your lender will come and seize your goods and assets and sell them to get their money back. This is never a good position to be in.
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.
All risks with investing can be mitigated with strategy. That is why it is so important to speak to a licensed financial adviser before you invest and especially before you borrow to invest. So if you are considering leverage, speak to an adviser about risk mitigation. Leveraging your investments can definitely be financially rewarding, but only when you properly understand and manage your risk and when it is backed up by a consistently high performing investment strategy.
