Leverage - Is This A Strategy For You?

Have you heard the term “leverage” when people are discussing their investments? This can be quite a confusing & 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.

This article is all about the risks & rewards of borrowing to invest or leveraging investment strategies. The information is general in nature & not intended as specific advice. As always if you intend borrowing to invest seek licensed financial advice before you do.

When I started investing my borrowing habits where the same as most peoples. I had a floating credit card debt which varied to my whims. I had a small personal loan for some household items & a bigger one which enabled me to buy my car.

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 & 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?

Borrowing to invest increases your ability to earn investment returns. Its simple maths really. You have more money to invest because you borrowed some so when you invest the money wisely you’ll earn more returns. There is one additional variable to this equation though to keep in mind the interest on the loan. Your investment strategy must be strong enough that the additional earnings are higher than the interest on the borrowings. Otherwise your net position is actually going backwards. Ie. Overall you are losing money.

The second benefit you can get from borrowing to invest is possible tax benefit. In my situation where I have borrowed to purchase an investment property in Victoria as I rent out that property & 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 & I borrow some money using them as collateral. I typically try & keep a 50% leverage ratio every dollar of stocks I own lets me borrow & 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.

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 & the interest. So you need to do your sums properly & work out whether your income can cover these repayments. If you mess this up & over-extend yourself typically your lender will come & seize your goods & assets & 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 & 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 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 money you invest exceeds the interest the borrowing accrues. If the interest is higher than the investment earnings you are losing money.

There are strategies to protect yourself against these risks though which your financial advisor can help you with. In my experience it definitely worthwhile borrowing to invest but only if you manage your risk & cashflow responsibilities properly. So the one piece of specific advice I will give you here is speak to a licensed financial advisor or accountant about whether this is an appropriate strategy for you. Only then should you work out how to structure it to match your personal circumstances.

Gnifrus Urquart has enjoyed significant success investing over the years. As such he likes discussing investment strategies & giving trading tips to anyone interested in investing Click here to get your own unique version of this article with free reprint rights.