Should You Borrow to Invest? Risks and Rewards

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:

1. During most of Warren Buffett's life, New Zealand mortgage interest rates averaged eight or more percent.
2. Contrary to popular belief, not all debt is bad.
3. Inflation erodes the real value of debt, which can work in a borrower's favour.
4. 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?
5. One of New Zealand's favourite investments is property, and one of the major advantages of property investment is the ability to borrow on favourable terms.
6. There are tax benefits, though it 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. Borrowing Costs vs. Historical Averages

For most of the last 40 years, New Zealand mortgage interest rates averaged eight percent or higher. Even when rates feel painful, they may still sit well below those long-term averages. Anyone funding a major purchase in a lower-rate environment is likely obtaining debt on more favourable terms than previous generations could.

Lower borrowing costs tend to ripple through the economy. Consumers have more disposable income. Banks lend more freely. Companies can take on debt to expand, which often pushes share prices higher. The same dynamic plays out in the property market, where cheaper credit tends to support rising values.

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 plan.

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

Value builders are assets 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

Value losers are assets which 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.

3. Inflation Works in Your Favour

Inflation is often seen as the enemy, but for borrowers it can be an ally. If you borrow $100,000 and inflation runs at, say, three percent over the following year, the real value of your debt drops to roughly $97,000 without you repaying a cent.

Why?

Because inflation erodes the purchasing power of money over time. The dollars you repay in the future are worth less than the dollars you borrowed. The higher inflation runs, the faster your debt shrinks in real terms.

4. Think Like a Business

The world's largest companies have been borrowing money at record levels, ramping up a trend going on for decades. It's not just struggling companies either. It also includes safer parts of the economy, like banking and tech.

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 with 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, possibly generating more of a return?
• What opportunities might you have overlooked, right in front of you?

5. Property Investors Do It

Investing in 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 making 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 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 plan (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 to?

The Bottom Line: Leveraged Investing

Leveraged investing can be a powerful tool, 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.

If you'd like to discuss your investments and overall financial situation with a trained professional, then get in touch.