As we have stated before leveraged investing is the practice of borrowing money to invest. It is a risky practice that can result in significant financial losses, but there are also several advantages to leveraging your investments. In today’s posting we focus on the advantages.
Access to Capital
Leveraged investments can be used to access more capital. In real estate, for example, a borrower can borrow 75 percent of the property’s value. For instance, a borrower with $50,000 to invest might use it as a down payment on a $200,000 mortgage, increasing his access to capital by 300 percent.
Because leveraged investing increases your access to capital, it also increases your profits if your investment pays off. For example, if you have $1,000 and you make an investment that has a 15% annual return, you would earn $150 in profit. If, instead, you borrow another $19,000 on top of your $1,000, then the investment would yield $3,000. Assuming that you paid interest of 12% on the loan, your cost would be $2,280, leaving you a net profit of $720 – 4.8 times greater than if you had simply invested the $1,000. So we can see that using leverage allows you to earn larger percentage gains on the amount you have invested. It multiplies your investment gains.
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. Leveraged investments in real estate can actually provide tax benefits. The interest payments on mortgages are typically tax-deductible, subject to certain limits. This deduction reduces the effective interest rate you pay. Another advantage of borrowing to buy real estate is that you increase your potential upside. We explained how this works in a previous post using an example of buying a house cash versus buying on mortgage.
You can use leverage to gain control over an investment that you could otherwise never afford. This is what happens in a leveraged buyout, when an investor borrows money to buy a controlling interest in a business. Having a controlling interest allows the investor to make unilateral decisions about the company’s strategy that best represent his own interests.
Leverage Makes Investments More Affordable
The cost of some investment types may be too expensive for many investors, and the use of leverage allows investors to participate with a smaller amount of capital. I know an investment platform where you need a certain threshold to be able to invest. But some innovative banks have used leverage to provides letters of credit on a certain leverage ratio to allow you access to the minimum amounts required for the investments.
Leverage Makes Some Markets Work for Investors
Some types of investments move in very small increments. Investing in these types of products would not make sense without leverage. Currency trading is a good example of a market that needs leverage. If you want to trade currency be very careful. I have seen many people being wiped out. I personally do not understand this investment type and caution people from investing in things that do not understand.
Building wealth with other people’s money. Many of us have bought homes with borrowed money. Typically, we buy houses with borrowed money because we are tired of renting or we think it is a great investment.
Forced Saving plan. One of the principles of wealth creation is to save money regularly. Some are good at this while for others it is challenging. Leveraging can be a means of forced savings. 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.
Leverage 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.
Using leverage as part of your investment strategy could help you reach your investment goals sooner. The use of leverage multiplies the gains for the same amount of money invested. The amount of leverage you can use depends on the markets in which you are investing and trading.
When used properly, leverage can be an amazing tool to build wealth. You’ve now heard some of the powerful benefits of leverage. Although it can be a double-edged sword and compound losses as well as gains, the prudent use of leverage can be a powerful tool. Tomorrow, I will discuss some of the risks associated with leveraging.