6 reasons why leveraged investing might be right for you
Mention ‘borrowing money to invest’ and you’ll usually receive looks of shock or confusion. If you don’t get a shocked or confused response, then maybe you’ll even have someone quote a wise investor, perhaps billionaire investor Warren Buffett, who once said:
“I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.”
Have times changed?
Far be it from us to disagree with Warren Buffett, but could times be changing? Could borrowing to invest sometimes be a sound move? Let’s consider the following:
Despite a few recent upward tweaks to interest rates (which most NZ economists think may continue for another year or so), they remain stubbornly low and are likely to remain low when considering long-term averages. During most of Warren Buffett’s life, NZ mortgage interest rates averaged eight or more percent, now they’re averaging around three.
Why are some of the biggest corporates in the world borrowing money, even though they have plenty of cash in the bank? Could individuals learn from them?
One of NZ’s favourite investments is property, and one of the major advantages of property investment is the ability to borrow on favourable terms.
There are tax benefits, though that should never be our sole reason for doing anything!
What Is Leveraged Investing?
Leveraging debt is using borrowed money for investment purposes to multiply your profits. These profits come from the difference between the investment returns on the borrowed capital and the cost of the associated interest. Leverage can be used to help finance anything from a home purchase to stock (share) market investing.
Leveraged investing exposes an investor to higher risk. Let’s take a closer look at why and when leveraged investing can be a good idea.
1. Interest Rates Are Stubbornly Low
That means anyone looking to fund a major purchase is likely to obtain debt on more favourable terms than what has historically been the case. Even if recent NZ law and regulatory changes are making things harder, NZ borrowers are still likely better off than they have been for the last few decades.
Generally speaking, low-interest rates are good for people who have money in the share market. When interest rates are low, consumers have more money to spend, and banks are lending more. Companies generate more revenue and can take out loans that can help them expand. This can cause their share prices to rise. You’ve probably also noticed recent rises in the NZ property market, which many have suggested is partly attributable to low-interest rates.
2. Not All Debt Is Bad
Contrary to popular belief, not all debt is bad. There are many instances where debt can be the best option for you or your business.
When carefully considered, taking on debt can be part of a secure and balanced financial strategy.
How do we know whether debt is good or bad? This can (often) be determined by what it’s spent on and the type of asset. There are two kinds of asset – value builders and value losers.
Value builders are assets that are likely to hold their value, grow in value, or bring in income after we’ve paid for them so, they can be okay to go into debt for. A house is an example of a classic value builder (although, houses can lose value too).
As a rule, if we keep a house for the long term (more than 10 years), the value will increase or stay about the same. And, if we needed to, we could sell the house and pay back our debt.
Education can also be a value builder as it can improve our job prospects and our income earning potential.
Value losers are assets that lose value after we’ve paid for them, like a common car. Every year the car is worth less. Borrowing to buy a car can be a risky move, especially if it loses value faster than we can pay off the debt.
At near-enough five percent, NZ’s inflation is the highest it’s been in 30 years. For borrowers, that’s great news, as it means that if you borrowed $100,000 a year ago, and you haven’t repaid a cent, in real terms you now only owe about $95,000.
Because inflation measures the real value of money, and over the last year that is roughly how much the value of dollars have fallen.
4. Think Like a Business
Apple, America’s most highly valued company, is swimming in cash. Apple is profitable and pays a regular dividend to shareholders. Despite this, like most major corporates, Apple is still borrowing on a huge scale.
Why would companies with plenty of cash still borrow?
Over the last year or two, companies have been borrowing money at record levels, ramping up a trend that’s been going on since well before the current crisis even started. It’s not just companies that are struggling either. It also includes safer parts of the economy, like banking and tech (including Apple).
Nearly every successful company around the world has used leverage to grow their business and become the success they are today. Companies use debt to finance their business operations, new equipment, technology, assets, and to buy competitors. For instance, an earthmoving company that owns several bulldozers may borrow to buy several more, and thus increase the ability of the company to move earth, which (if done carefully) should increase profits.
The trick is to know which are the right circumstances and opportunities when a business should borrow money.
Broadly speaking, the same principle applies to individuals
“I'm not a businessman, I'm a business, man!” – Jay-Z. Rapper, businessman, billionaire.
Taking your personal finances to the next level means thinking then acting on another level. That could include treating your personal finances like a business.
How can you invest more to boost your knowledge and ability to earn?
What physical assets could you acquire that may generate more of a return?
What opportunities might you have overlooked that are right in front of you?
5. Property Investors Do It
Residential real estate (property investment) is a Kiwi favourite.
Real estate is one of the few investments where you can borrow funds to invest more than your available capital and increase your overall return on investment.
Most New Zealanders are familiar with the concept of borrowing to buy a home or investing in another property. The relative ease of obtaining this kind of borrowing, and the levels available, make this an obvious starting point for anyone interested in leveraged investing. However, the same principle can also apply to other investments such as shares or businesses, other traditional investments, or even ‘non-traditional’ investments such as training and education.
6. Tax Benefits
In most countries, any money spent on interest as a result of borrowing to invest is nearly always a deductible expense. This is part of globally accepted best practice when it comes to taxation. Why?
Because the governments that make the tax rules want to encourage economic activity. They want to encourage responsible borrowing to keep funds circulating through the economy, and to keep the economy growing.
Favourable tax treatment is one of the many reasons that major corporates so readily borrow, and even if you’re not a major corporate, or even a business owner or property investor, the Inland Revenue Department (IRD) says:
“You can claim interest on money you’ve borrowed to buy shares or to invest, as long as that investment will produce taxable income.”
In other words, leveraged investing could mean you pay less tax.
Buyer Beware - Borrowing to Invest Is High Risk
Even though the above six topics might make a good case for leveraged investing, it is still risky to borrow to invest and isn’t for everyone. The more you borrow, the more you can lose.
Borrowing to invest requires:
Strong and steady cashflow. To make repayments.
Discipline. You’ll need to hold your nerve if the investments you’ve borrowed to buy don’t perform as expected.
A good risk tolerance. As the potential losses are amplified many times over.
Good knowledge. You’ll need to know what you’re doing and be able to accept and manage the risks. This will probably include building some sort of safety net, running multiple scenarios to test your strategy (called an investment stress test), and close monitoring of all areas – most especially cashflows and debt to equity ratios.
Crucially, before you launch into leveraged investing it’s also worth understanding whether you need to borrow at all. If you’re already well on-track to achieve your major life’s goals, then why go to the trouble and take on risk you don’t need too?
The Bottom Line
Leveraged investing might never have looked so good, but it’s not for the faint-hearted! If you think this might be for you, then do your homework, and mitigate any risks before leaping in.