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 covers the general principles of leveraging your investments. If it is something you are considering but have never done before, discuss your ideas with a licensed financial adviser. They will ensure you are structured correctly and can minimise your risk and exposure.
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.
Why is it more efficient to use your borrowings for investing then?
Firstly, when you borrow to invest, you are “using other people’s money” to earn more money in the investment markets. A great example of this is in our FX Trading strategy. If I invest $10,000.00 and leverage it out at 400:1 that means I have $4,000,000 invested. This above example describes very well the first benefit of leverage. By accessing more money to invest, you can earn way higher returns on your investments than you otherwise would have been able to.
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 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.
Finally there is the investment risk. When you borrow to invest, you do so with the intention that the income earned from the money you invest, exceeds the interest the borrowing accrues. If the interest is higher than the investment earnings, you are losing 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.
Gnifrus Urquart has had significant success investing over the years. As such, he enjoys reviewing investment strategies and offering trading tips to others interested in investing
hmm,Have you heard the term “leverage” when people are discussing their investments? This can be quite a confusing and daunting concept for many people. But all leverage really means, is borrowing to invest. The reason people call it “leverage” is because typically existing assets are used as the security or basis of the borrowing. That is, you leverage off the value of a current investment or asset, to borrow more money to invest.