Borrowing to invest is known as leverage, and can be quite effective in building wealth, businesses, and incomes. Leveraging enables investors to increase their returns when markets are rising but can yield devastating returns when the markets fall. For instance, should an investor take on 50% leverage, i.e. borrowing an equal amount to initial equity, he/she will be able to generate 2.0x the investment return. Thus, borrowing increases risk and can expose an investor to greater losses.
Here are the four ways to leverage your money, some of which you may already utilize:
Leveraged Home Ownership
Borrowing to buy a home in a mortgage is the most common form of leveraging. Through mortgaging, homeowners build equity as they pay off down their mortgage while at the same time, reaping the benefits of an appreciating asset. However, mortgages can be devastating investments if the mortgaged property depreciates in value beyond the equity accumulated. When you decide to sell, you might find yourself in debt considering the down payment plus equity accumulated during the period, less all the expenses that go into selling a property i.e. sales commission.
How It Works
The effectiveness of leverage in homeownership can be achieved as follows, in the simplest terms:
You put a Kes. 1 M down payment on a Kes. 10 M house. If the house appreciates in value by 10% over the next year. You could walk away from this deal with Kes. 11 M (not accounting for commissions and other erroneous expenses) if you choose to sell after a year. Thus, in one year, you made Kes. 1 M on your initial investment of Kes. 1 M. So although the house itself increased in value only by 10%, your personal return on investment is 100%. On the other hand, if the house depreciates in value beyond the equity you have managed to accumulate, you may achieve losses on sale.
Risks & Notes:
- Interest rate risk on the mortgage could rise. Always asses the pessimistic and optimistic scenario of every investment you make. Here, seriously consider the details of your contract – floating or fixed interest rates – considering if you could still meet loan repayments if interest rates rise or fall?
- Income risk should always be considered by mortgage takers – in the event of sickness, injury or redundancy. Consider ways in which you can retain your property or make gains in the event of anything.
- Mortage holders are eligible for tax relief.
Leveraged Business Investment
Business debt is a truer form of leverage as you can borrow with the expectation of earning an income, which makes interest on the loan tax-deductible. Interest risk on top of the capital risk increases the risk exposure of any investor. If the business capsizes and there is nothing to sell, then bankruptcy could be imminent. We have all heard tales of business owners losing everything and others becoming wildly rich in achieving their goals with good business investments. Ultimately, nothing wagered is nothing gained.
How it Works
The effectiveness of business leverage can be achieved as follows, in the simplest terms:
Similar to the above example, you can invest in Kes. 1M down on a $10M business idea. The business can make Kes. 1M/year. You can use this income to help make loan payments. However, the success of this all depends on the business – you may find that there is capital appreciation i.e. having a loyal customer base and good reputation. These things may enable you to sell your business for more than Kes. 1M. This overall gain on the amount can be expressed as a greater return on investment on your initial investment of Kes. 1M plus loan payments.
Risks & Notes:
- Do your own due diligent and meet with your business mentor. In business, learning from others mistakes is the best way to get an idea of what to expect. Keep your ears peeled for tales of woe, as well as tales of abundance.
- In business, capital risk is always present as your business may fail or revenues may not be able to cover the debt. It is always advisable to have a cash reserve set aside for this specific problem to avoid liquidation or eventual bankruptcy.
Leveraged Real Estate Investment
The idea to borrow to invest in real estate takes on both business and home ownership strategies of leveraging – rental income and value appreciation. The only drawback to this investment strategy is that there will be times when you don’t have tenants to help you pay up the mortgage. Eventually, cash-strapped or not, you will have to come up with the resources to finance the loan. Also, losses are also another risk to consider when it comes time to sell off real estate.
Risks & Notes:
- Income risk should be considered. What is your plan to manage it? Have extra cash reserve on hand for days when income isn’t forthcoming to cover loan payments.
- Conduct your own due diligence or consult a real estate agent/financial planner and find out how leverage works and draw up a pessimistic and optimistic return scenario for your investment.
Leveraged General Investment
The attraction behind investment leveraging is best achieved when the interest rates for borrowing are low. In leverage investments, gains are magnified and this can be quite addictive. One needs to be cautious because no matter how impressive the numbers are, they can all evaporate when multiplied by a single zero. If you choose to take this route, then ensure that you adopt a long-term investment strategy which will give your portfolio enough time to recoup from any market dips.
How It Works
The effectiveness of investment leverage can be achieved as follows, in the simplest terms:
Leveraging investments can be quite complicated as experienced investors love to use derivatives, futures contracts, and swaps to magnify returns. Here, I wouldn’t want to complicate this for you guys. However, put simply, ensure that your returns are more than the interest you pay for the borrowed funds i.e. If your investment makes 8% or Kes. 80,000, and you subtract the Kes. 30,000 in net interest expenses, your gain is Kes. 50,000. If you express the Kes. 50,000 as a return on your investment of Kes. 1M you just made a 5% return. If you can find someone to loan you money at 3%, then you are good to go.
Risks & Notes:
- Take on a long-term investment strategy to allow assets to appreciate and recover from bumps and corrections in the market. This is particularly important since leverage magnifies both losses and gains, creating bigger swings within your portfolio – don’t panic!
- Do you own due diligence or consult with a financial planner to asses your exposure and ensure that you aren’t trading a losing account.
- We have established that leverage magnifies gains and losses, therefore, your capital is always at risk. You may lose far more than you bargained for with margin debt. Always be careful.
- Trust your gut – go for it – leverage is very risky. It takes a strong unflinching investor to not break a sweat out of worrying about debt. If you think you can do that, then you are good. Trust me, it’s a rollercoaster ride you don’t want to get on. If you know you can’t handle it, choose to be healthy and adopt a stress-free investment plan.
Bottom Line
Everybody wants shortcuts to building wealth, and debt is the fastest way to get there. Personally, I’m not advocating for it. However, I can write about it to draw attention to some of the concerns with leveraged investments. Before investing, you should strongly consider what can happen if you hold securities for longer than a day and whether the extra risk fits with your financial goals. Most of all, can you handle the extra the roller coaster of making leveraged investments.
Overall, be careful with the money you are investing!
Meanwhile, You can click on the following links to read more about investing:
- How to Overcome the Fear of Losing Money
- Kenya’s Highest Dividend Paying Stocks
- How to Produce Income From Investing Forever
- How to Build Wealth Rapidly
Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.
