Leveraging has become the taboo word during this recession, and not unfairly. Companies and banks had been leveraged heavily causing a global financial crash, however leverage can be a good strategy if done carefully.
Derek Foster discusses leveraging in his new book “Money for Nothing” Canadian Capitalist and Four Pillar’s have a review. Although I do not agree with his book, I am a believer in leverage under certain circumstances.
Leveraging, although risky, can be a good investment strategy if you build a strong portfolio and understand the risks associated with leveraging.
What is leveraging?
Leveraging is basically investing with money borrowed from other sources. A familiar use of leverage is a mortgage, you get a loan from a lender to purchase the home with a small down payment. You hope the value of your property goes up this will magnify your profit.
A simple example
You purchased a $200,000 home with $40,000 down payment and $160,000 mortgage four years later the property is worth $300,000, how much is your profit? $300,000-$160,000= $140,000 in profit, you have 350% return on your initial down payment. Note: This is just an example, does not include interest and other costs.
I don’t see a house as an investment, but it illustrates the concept very well. It is clear from the example above that leverage magnifies your profits and that is the purpose with this strategy. But it can also magnify losses, discussed below.
How does Leveraging work?
1. You get a loan from the bank for the amount you wish to invest
2. You invest that money and pay the interest (also have the option of paying back the principle if you wish to do so).
3. You pay back the loan and keep any profits from it.
Benefits of Leveraging
As stated earlier through leverage you increase your potential for higher return, it magnifies your returns. Although you have to pay interest on the loan, under CRA rules interest paid on investment loans to generate an income is tax deductible.
Risk with Leveraging
There is a big risk associated with leveraging, if your investment goes down in value your losses will be magnified.
Example:
You Invest $120,000 with $100,000 of it being borrowed funds and market declines 50% your investment value will be $60,000 for a total loss of $60,000 your return on investment is -200%!.
So beware of the risk associated with leveraging.
Who should use leverage?
Leverage is a very aggressive investment strategy and only those with high risk tolerance and long time horizon should consider leverage.
I personally like leveraging to a certain extent, I do not over leverage and do not buy speculative investments, buy income generating investments and watch them carefully.
Million Dollar Journey has a two part post on “Myths about levering”
What are your thoughts on leverage?
Ray is an ex-financial adviser and the founder of Financial Highway. Currently working in the financial industry and working towards completing his Chartered Financial Analyst, CFA, designation.