One time I heard leverage being compared to a pop tart. When ‘pop tarts' are eaten cold, they are not too interesting. But heat them up and pop tarts take on a different life. Some might say that leverage is much like heating up an ordinary investment portfolio giving it a new flavour and a more interesting taste.
What is leverage?
By definition, leverage is any process that compounds risk. In the context of investing, leverage is the process of using borrowed money (someone else's money) to try to make money. The risk comes into effect if you lose the money; you are losing money that you do not have.
Borrowing is not new
Think about it, you borrow money in our every day lives. We borrow to buy our homes, we borrow to buy depreciating assets like cars and we also borrow to buy assets that have no value like consumer goods. Most of the time we borrow to do things that are not financially productive. Leveraging can be incredibly productive when it is understood and used properly.
Benefits of leverage
- Building wealth with other people's money. Many of us have bought homes with borrowed money. In fact, you can buy a house today with only 5% down. The other 95% is leveraged by the banks. Typically, we buy houses with borrowed money because we are tired of renting or we think it is a great investment. The 2 biggest problems with house leveraging is that the interest costs are not tax deductible and the amortization of a mortgage causes you to pay more interest in the early years and very little principle. Leveraging into mutual funds can be more beneficial in that you can pay interest only and the interest you pay is tax deductible. If you are comfortable making an investment into home ownership with borrowed money, you might consider the merits of investing into mutual funds with borrowed money.
- Boost your effective returns. Leveraging can magnify your return both on the upside and the downside. Let's take a look at an example. Say you had $10,000 to invest and you were able to earn 10% in mutual funds. Assuming the growth is capital gains, your return after you paid tax would be about 8.05% (assuming a 39% marginal tax rate). If your identical twin took the $10,000 and borrowed an additional $10,000 to make a total investment of $20,000, he/she, assuming the same return and marginal tax rate, would have return of 11.5% after paying taxes and accounting for interest payments (that is a 43% incremental return). In this example if your twin borrowed $20,000 instead of $10,000 and invested $30,000, the returns get magnified even more to 15% after taxes and interest costs. Boosting your returns can help you to build wealth much faster.
- Interest payments create a tax deduction. We are always looking for ways to reduce the amount of tax we pay. Most of the money we make is used in ways that are not tax efficient. Borrowing money to invest in income producing investments can create a tax deduction from your income. For example, if you borrowed $10,000 to invest in mutual funds, and your borrowing rate is 7.5%, you would be paying $750 a year in interest cost. However, because that interest is tax deductible, you would save $292.50 in tax.
- Forced Saving plan. Recently, Statistics Canada released a study showing that 30% of all Canadians do not have any RRSP savings. In fact many of us have a tough time saving enough money for the future. In the Wealthy Barber, by David Chilton, he stressed the importance of investing 10% of your income on a monthly basis as a method of forced savings. Alternatively, leveraging can be a means of forced savings too. The difference is you would invest a lump sum of borrowed money and your money would start working immediately. On a monthly basis, you would be paying the interest instead. Any way you do it, forced savings is essential to building wealth.
When used properly, leverage can be an amazing tool to build wealth. You've now heard some of the powerful benefits of leverage. Next week, I will discuss some of the risks associated with leveraging.