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.
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?
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 are definite advantages you can gain from leveraging your investments. There are risks also though, which is why you should seek proper financial advice prior to moving down this path.
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.
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.
There are strategies to protect yourself against these risks though which your financial advisor can help you with. In my experience, it is definitely worthwhile borrowing to invest, but only if you manage your risk and 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.
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