The risks of leveraging
Last week I talked about all the good things about leveraging, a concept that involves borrowing money to try to make money. With every incremental reward scenario, comes potential risk.
Sometimes, the concept of leveraging gets a bad wrap. This often comes from investors who have been the recipient of a slick salesman preaching all of the benefits of leveraging without disclosing any of the risks.
Leveraging can be extremely productive but it is not for everyone. Before anyone considers leveraging as part of their wealth building strategy, be sure to understand the risks.
- Investment Risk – like any investment plan, investment risk is a reality. In leveraging, you must invest the proceeds of borrowed money. Leveraging does not prevent you from just making a bad investment decision.
- Magnification of losses – last week I gave some examples of how leveraging can boost your effective returns. Unfortunately, leveraging can also magnify your losses. For example, let’s say you had $10,000 to invest and markets dropped and you were facing a loss of 10%. If you needed the money, 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 (at 7.5%) to make a total investment of $20,000, he/she, assuming the same return and marginal tax rate, would have return of -20.7% after paying taxes and accounting for interest payments. In real dollars, this means your $10,000 has lost $2067.50. In this example if your twin borrowed $20,000 instead of $10,000 and invested $30,000, the losses get magnified even more to -33.3% after taxes and interest costs.
- Interest Rate Risk – There are a number of variables that affect your total return like tax, investment return, and the cost of the loan. The key to successful leveraging is to have your after tax investment return exceed your after tax cost of interest. Therefore, rising interest rates can potentially have a negative effect on your leverage returns.
- Cashflow Risk – Rising interest rates has a ripple effect on your cash flow. If you are going to leverage, you must maintain the interest payments on the loan. If interest rates go up, your interest payments will increase accordingly. Prudent leveraging will ensure that you budget for the potential of higher interest rate costs.
- Margin Call Risk – One of the biggest risks of leveraging is the dreaded margin call. The margin is the difference between your investment portfolio value and the amount of the loan. If the markets drop and falls below a certain margin, the lender can issue a margin call where you will have to put in more money to make up the difference. Margin calls always happen at the worst possible time. To help minimize the risk of a margin call, you can secure the loan with an asset like your home. Otherwise it is imperative that you only leverage within your financial comfort zone. Always budget a cushion in case the dreaded margin call is made. Some institutions now have leverage programs that guarantee no margin calls.
- Tax Risk – Remember that success in leveraging requires that your after tax returns must exceed your after tax cost on the interest. Changes in tax rules could potentially hurt your leveraging program. For example, if the government made changes to the tax laws disallowing the tax deductibility of interest, you would have to re-evaluate the merits of leverage.
- Emotional Risk – Fear and greed can reek havoc on any investment plan. It is even more important to keep a level head and direct decisions using logic instead of emotions. Being able to sleep at night is key with leveraging because there are so many variables that can affect the success of a leverage plan. If you are at all uncomfortable emotionally with making interest payments, facing loss or any of these risks, think twice before borrowing to invest.
The bottom line is leveraging is a tremendous tool to build wealth. Before you jump in with both feet, take the time to understand the risks. Consult your financial advisor to see if leveraging makes sense for you.