Debt Leverage: Beware of Leveraging Too Much for Investments

Leveraging debt for investment is a strategy that has become popular during multi-year bull markets. And there is no doubt. borrowing to expand an investment portfolio on the way up can do wonders, but we must never forget that what goes up must come down. As for investments, debt leverage is a double-edged sword. it increases up and down steps.

In this Guide:

Using Debt as an Investment

There is no doubt that leverage can be an ally in bull markets. If you have a $50,000 investment portfolio and borrow an additional $50,000 to grow the portfolio to $100,000, a 20% gain on your portfolio doubles your return from $10,000 to $20,000.

If you can borrow money at 5%, you'll only pay $2,500 in interest for a year on $50,000. Since you will earn $10,000 (20%) from the additional investment over the same period, the loan will generate an additional $7,500 in profit ($10,000 investment profit, less $2,500 in interest paid on the loan).

This is a strategy worth doing anytime, and you can use services like Monevo to compare loans from the best lenders and banks.

The Problem With Leveraging Debt

But the problem with leveraged investing is that the same situation works in reverse when the market is down. And no matter how strong the market looks, it is an inescapable fact that bull markets are followed by bear markets.

Let's use the same numbers, but assume that the market is down 20 percent in one year. Instead of doubling your returns by doubling your investment through the use of loans, you double your losses.

If you didn't take the money and stuck with your original $50,000 investment, a 20% drop would result in a loss of $10,000 worth of investment. But by doubling your investment portfolio using debt, a 20% loss turns into a $20,000 hit.

Given that your real estate is only worth $50,000, this means your actual loss is 40% ($20,000 divided by $50,000). But we are not done yet. The interest rate factor is applied to the reduction in the same way as above.

The $2,500 in interest you paid on the loan portion of your portfolio would increase your total 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 the net worth of your portfolio.

That's the downside of leveraging debt with your investments.

Ways You could be Leveraged without Knowing

One of the problems with leveraged investing is that it's not always obvious. You can use your portfolio in ways you might not normally think of.

Here are some examples…

1. Margin Loans

Margin loans are the most obvious way to 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.

Because this is very deliberate leverage, investors tend to minimize it, and because loans are directly tied to your investment portfolio, it's easy to do. If you forget, your broker will remind you with a margin call.

2. Loans Against a 401(k)

Because 401(k) loans are typically taken out for purposes other than investment leverage, we cannot classify them as investment-related debt. But it is what it is.

You can borrow money to buy a car or make a major renovation to your home, but because the money is borrowed primarily from an investment account, it's actually investment-related debt.

3. Credit Card Debt

Credit card debt can be a silent form of investment debt, and therefore a form of leverage. Although this is usually not the case if you maintain relatively low balances, and especially if you pay them off in full each month. But if your credit card debt becomes substantial, it can be a form of investment leverage.

Consider a scenario where you have a $50,000 investment portfolio but $15,000 in credit card debt. The debt is equal to 30% of your portfolio value and is completely unsecured. What you're doing is investing your money at, say, a historical average return of about 8%, but paying closer to 10% on your credit cards.

With that arrangement, you're losing money at an average rate of about 2% per year. Although credit card debt isn't tied to your portfolio, it's still a losing proposition and represents a form of leverage that's indirectly linked to your investments.

Borrowing to Fund Investing

Then there is the most embarrassing type of loan, which is borrowing money directly to invest. Saving up enough money to start an investment portfolio is difficult to do with today's high cost of living. Sometimes people are tempted to take a significant amount of money for the initial portfolio.

The money can be borrowed in the form of “good debt,” such as a home equity line of credit or a cash-out first mortgage. You can even borrow from a 401(k) plan.

These loans are modest compared to margin loans and credit card debt, even if you borrow money for investment purposes, you still benefit from your investment. And that means you take more risks.

When borrowing money for leveraged investments, one must always remember that the repayment of the debt is secure, but the return on the investment is not.

A limited amount of leverage, in the right investment vehicles at the right time, can improve the performance of your portfolio. But too much debt invested at the wrong time and in the wrong investment vehicles can put you in the poor house.

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