Investing With Leverage For Wealth
Posted in MoneyOne of my hobbies is cars. I like both new and old ones but mostly those with a sports car feel to them so I can experience the thrill of tight corners in a well-balanced car. Since I like cars so much I have a hard time resisting to buy them and because I am not rich (yet) I usually end up with an older beat up car in need of some tender loving care. Normally I fix my car myself when it breaks down so I have a bit of car-wrenching experience. Some times (especially with old cars) the nuts and bolts are so rusted that they are practically fused to the car and will not budge simply by putting a wrench to them. Which brings me to my point - you can often get the nut/bolt off if you extend the wrench with a metal pipe and use your force at the end of this extension. A nut or bolt that was previously impossible to budge can often become a piece of cake; either that or something breaks! Given a long enough extension something will budge.
This principle is called leverage and you have probably learned about it in physics-class and used this moment of a force formula for your homework :
This formula says that using a lever the moment of a force (M) equals the force applied to the lever(F) times the distance from the object(d).
In everyday life you do not need to know this formula, it is sufficient to know that using such leverage can drastically increase the force you can apply to an object. You use this principle every time you open a door - if the door handle/knob was placed in the same side as the hinges, opening the door would become much harder but thanks to the leverage gained by placing the handle in the opposite side you can open even large and heavy doors effortlessly.
It should come as no surprise that leverage can be used in many areas of your life, including your personal finances. In financial matters you typically use leverage by borrowing some or all of the money you invest. Let’s use the example that you have saved up $100.000 that you want to invest in real estate in order to get a better return on your savings (and you do not mind the extra risk compared to for example bonds). For those 100 grand you buy a house which you will then rent out in order to get some cash flow from you investment, while at the same time you build equity in the house because the prices in the neighbourhood is expected to increase by 6% a year. Assuming this expectation to be correct, that you can get 800$ in rent and that your monthly expenses maintenance of the property are 100$, this is how your investment will evolve in a 10 year period :
So after 10 years your original $100.000 has grown to $179.085 in equity and given you $84.000 in cash flow for a combined worth of $263.085 - not bad! Now let’s try the same example using leverage. In order to leverage your $100.000 you find 5 similar houses each costing $100.000 but now you only put 20% down and mortgage the remaining 80%. Your mortgages have a fixed rate of 5% and lifespan of 30 years so in addition to your 100$ in maintenance expenses per house you will now have $2147 in monthly repayments on the mortgage. With these numbers the graph will look like this :
Yielding $570.055 in equity (after subtracting the remaining $325.369 of the mortgage) and $162.360 in cash flow for a combined worth of $732.415. This gives you an ROI (Return On Investment) of 732% over a 10-year period compared to 263% when not using leverage. This shows how leverage can be very powerful financially as well.
That you will get a better return by borrowing money might be common sense to you, especially in an example as obvious as this (equity increases 6% while the mortgage is only 5%), but the fact is that for a lot of people it does not come naturally to borrow money as part of an investment. If you have worked for many years, each month saving a bit of your pay check and paying off the mortgage on your house in order to finally have that $100.000 to invest, it will probably seem like a counterproductive move to immediately go into debt again in order to finance your investment. But hopefully it is clear from this article that borrowing for consumption (like a place to live) is financially very different from borrowing for investing.
Remember the example with the rusted nut? With a long enough lever it will either budge or something breaks. The same thing applies financially, by using leverage you will be much worse off if something disastrous should happen. If for example your tenants in the house for some reason trashes the place or the city administration decides to place drug rehabilitation centre next to it, your equity might go down by 6% instead of up. This will make the leverage work against you!
So the conclusion must be that given the right circumstances you would be foolish not to use financial leverage to your advantage, but you should always be cautious not to let the power of leverage turn against you and risk management should be at the top of your priority list.
[...] Investing With Leverage For Wealth [...]
Pingback by Carnival of Investing #22 on InvestorGeeks — May 15, 2006 #
Using financial leverages for investing is usually dangerous for amateurs. The reason is that the leverage works both way, magnifying both your gain and loss. An amateur trader often don’t know when to cut their losses, or being too emotional with the market, and ends up losing more money. I only recommend using leverages under some circumstances. Click http://www.1stmillionat33.com/2006/04/leverage-the-secret-of-making-big-money/ for my leverage post.
Comment by frugal — May 15, 2006 #
“it does not come naturally to borrow money as part of an investment”
The reason is because on a downturn you could be leveraged out and lose part or all of your investment. One should never ‘margin’ their entire stock portfolio or ‘leverage’ their entire investment portfolio. It is risky.
Disclosure:
This comment was written by a CrossProfit analyst. This is a personal comment and may not reflect the opinion of CrossProfit.com.
http://www.crossprofit.com
Comment by CrossProfit — May 16, 2006 #
Yes, the stock market will only go up on and of for time and all eternity. Therefore, let us borrow money to invest. Surely I loans will never be called, leaving us and the nation bankrupt for a generation.
Comment by Great Depression — June 4, 2006 #
I think “Great Depression” missed the point entirely.
In the article I am talking about real estate and not stocks. Real estate have the nice side-effect of giving you money from rent and therefore things have to go pretty bad in order for you to get in big trouble.
In addition I am not saying you should just borrow money regardless of the circumstances, of course not. Using leverage should be seen as a tool, nothing more. You should not use leverage for investing in very high risk business (such as penny-stocks). You should also not disregard leverage on the basis of it being too “risky” if you have a very good deal on your hands with limited risk.
For a follow-up to this article see Living In A World Of Risk : http://www.scheelmeyer.com/blog/2006/05/20/living-in-a-world-of-risk/
Comment by alexscheelmeyer — June 5, 2006 #