Leverage is simply investment jargon for borrowing. Its called “leverage” because you use the value of an existing investment to underwrite, or as security for, the borrowing.
If you have not borrowed to invest before, but are considering it, you really should discuss this with a licensed financial advisor before you do. The concepts provided in this article are general in nature and should not be taken as specific advice to be applied to your specific circumstances. A financial advisor will be able to tailor a borrowing structure which perfectly matches your goals.
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.
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?
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.
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.
This works exactly the same in the margin loan I am using to help with my stock market investments. I have borrowed some money in a margin loan (I usuall try and keep the leverage here at about 1:1, so every dollar of my own I invest gives me another to invest) and pay interest every month on that loan. My stock market strategy pays me my consistent income every month, which is more than the interest on the margin loan. And then, at the end of the tax year, I deduct the interest payments from the money I earned, gaining a tax advantage.
Those are some of the benefits you can gain by borrowing to invest. There are risks too though, so it is very important to get independent financial advice if you are thinking about leverage.
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.
A margin loan is treated a little bit differently. If you borrow too much or the value of your investments drops suddenly, you will be at risk of paying margin calls. This means your lender will ask you to pay off a portion of the loan, so that the outstanding loan is in a reasonable level when compared to the reduced level of collateral. This can be quite a large issue if your investments drop by a long way. If you cannot meet the margin call obligations, your lender has the right to sell your investments.
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.
|
|