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.
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.
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.
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.
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.
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.
In a margin loan situation, it is a little different. If you borrow too much here, you may breach the allowable % of assets to debt you are given and if this happens, you will be expected to put more money in to put the loan back in “good order”. This can be quite difficult if the market swings strongly against you. So you need to know that in extremely adverse market conditions (2007 - 2009 are a good example of this) you can generate enough income to cover such margin calls.
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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Tags: Credit, currency trading, Finance, forex, investing, Leverage, Loan, Loans, money, money management, Mortgage, property, Real Estate, stock market