Using debt as an investment
There's no question that leverage can be a friend in rising markets. If you have a $50,000 investment portfolio, and borrow an additional $50,000 to increase the portfolio to $100,000, a 20% gain in your portfolio doubles your return from $10,000 to $20,000.
If you're able to borrow the money at 5%, you would pay just $2,500 in interest for one year on $50,000. Since you will earn $10,000 (20%) on the additional investment over the same amount of time, the loan will produce an additional $7,500 in returns ($10,000 in investment earnings, less $2,500 in interest paid for the loan).
That’s a strategy worth doing any time, and you can use services like Monevo to compare loans from top lenders and banks.
The problem with leveraging debt
But the problem with leveraging investments is that the same situation works in reverse when the market is falling. And no matter how strong the market looks, it’s an inescapable fact that bull markets are followed by bear markets.
Let’s use the same numbers, but assume the market falls 20% in one year. Instead of doubling your return by doubling your investment through the use of loans, you double your losses.
Had you not borrowed any money, and stayed with your $50,000 initial investment, the 20% slide will result in a $10,000 loss in investment value. But by doubling your investment portfolio with the use of debt, the 20% loss translates into a $20,000 hit.
Considering your real equity is just $50,000, this means your real loss is 40% ($20,000 divided by $50,000). But we’re not done yet. The interest rate factor applies on the way down — just as it does on the ride up.
The $2,500 interest you paid on the loan portion of your portfolio will increase your overall loss to $22,500. That’s the $20,000 loss in investment value, plus $2,500 in interest on the loan. Now your loss is up to 45% of your net portfolio value.
That’s the downside of leveraging debt with your investments.
Ways you could be leveraged without knowing it
One of the problems with investment leverage isn’t always obvious. You can be leveraging your portfolio in ways that you normally don’t think about.
Here are some examples…
1. Margin loans
Margin loans are the most obvious way you can leverage your investments. You do this through your broker and can borrow up to 50% of the purchase price of your investments when you buy them.
Since this is very intentional leverage, investors typically keep it to a minimum, and since the loans are directly tied to your investment portfolio, that’s easy to do. If you should forget, your broker will remind you with a margin call.
2. Loans against a 401(k)
Since 401(k) loans are typically taken for some purpose other than investment leverage, we may not classify them as investment-related debt. But that’s exactly what it is.
You may be borrowing the money to purchase a car or make needed major repairs on your home, but since the money is borrowed against what is essentially an investment account, it is in fact investment-related debt.
3. Credit card debt
Credit card debt can be a silent form of investment debt, and therefore a form of leverage. Though this is generally not the case if you keep relatively low balances, and particularly if you pay them in full each month. But if your credit card debts become substantial, they can be a form of investment leverage.
Think about a scenario in which you have a $50,000 investment portfolio, but $15,000 in credit card debt. The debt equals 30% of your portfolio value, and it is totally unsecured. What you are doing is investing your money — let’s say at the historical average return of around 8% — but paying something closer to 10% on your credit cards.
With that arrangement, you are losing money at a rate averaging about 2% per year. Even though the credit card debt isn’t tied to your portfolio, it’s still a losing proposition and represents a form of leverage indirectly related to your investments.
Borrowing to fund investing
Then there is the more blatant type of borrowing, which is borrowing money directly to invest. Accumulating a large enough block of money to begin an investment portfolio is difficult to do with today’s high cost of living. People are sometimes tempted to borrow a substantial amount for the initial portfolio.
The money may be borrowed in the form of “good debt”, such as a home equity line of credit or a cash-out first mortgage. It may even be borrowed from a 401(k) plan.
These loans are tame compared to margin loans and credit card debt, even if you are borrowing money for investment purposes, you're still leveraging your investments. And that means you are taking on a higher risk.
When considering borrowing money to leverage investments, you should always remember that debt payments are certain, but investment returns are not.
A limited amount of leverage — at the right time in the right investment vehicles — can improve the return on your portfolio. But too much debt invested at the wrong time and in the wrong investment vehicles can land you in the poor house.