Leverage: How Debt Magnifies Returns

Debt, when used respectfully, is an excellent way to magnify your investing returns and produce long lasting wealth. This is explored below.

We are quite used to borrowing

Borrowing allows people to access assets, like home and investment property, and large share portfolios, that many could not afford if it was not for the ability to take out debt for the asset.

Even if you contribute a small amount to the purchase of an asset, and use debt to fund the balance, in most cases you will receive 100% of the returns generated by the underlying investment.

This has the effect of magnifying the return on your capital investment.

 

Example 1: debt on a property investment

Lets say Will buys an investment property for $500,000 using a 10% deposit of $50,000. The property earns an annual rent of $25,000.

Thats a 5% return on the value of the property, but a 50% return on the value of the initial capital ($50,000) that Will has put into the deal. 

It works the same way with shares.

Example 2: debt on a share portfolio

Lets assume Kate has $100,000 in cash and a $100,000 loan with which to buy $200,000 of shares. The shares are priced at $20.00 each, meaning she buys 10,000 shares.

After one year, the $20 shares have now risen to $24. This means Kate's portfolio is now worth $240,000, a gain of 20%. 

However, Kate put in only $100,000 of her own capital to buy the shares, so the $40,000 rise in value of her shares works out to be equal to a 40% return on her capital.

Income tax benefits of gearing to invest:  Tax benefits on investment loans (the deductible interest you can claim) can be seen as a second rent cheque, as they are a reduction (or refund) of tax connected to ownership of the property or shares and forming part of the economic return or reward for owning the assets. 

Income tax benefits of gearing to invest: Tax benefits on investment loans (the deductible interest you can claim) can be seen as a second rent cheque, as they are a reduction (or refund) of tax connected to ownership of the property or shares and forming part of the economic return or reward for owning the assets. 

Double edged sword

This is how borrowing to invest can magnify your returns on investment, which is one of its main appeals. Be aware that using it can be a double edged sword that works against investors when markets fall or the wrong asset has been chosen (i.e. a dud investment property or an over hyped and poor performing stock).

How can you mitigate the risks of using debt to invest?

Risks can be mitigated when investing and using debt for investment via some simple principles and a well considered strategy.

Some main ways to mitigate the majority of the risks are:

  1. Select the asset wisely (blue chip property and shares)

  2. Ensure you can manage small hits to cashflow (i.e. are you a high income earner? Do you have a stable financial position?)

  3. Use a conservative Loan-to-asset value gearing (i.e. 95% lending on an asset is riskier than 60, 70 or 80%)

  4. Seek debt that is well priced - home loan debt is usually the cheapest form of debt out there. Also see the Aspiire article on The Golden Rules of Tax Deductible debt.

  5. Insurance. Insure yourself with Income Protection and other types of insurance, in case you lose your health and the ability to earn income (and to service the debt). Also see the Aspiire article on Protecting Your Assets.

  6. Look for cashflow positive or neutral investments

  7. Diversify - having only Banking or Mining stocks, or only property investments in one suburb is like having all your eggs in one basket.  Broaden your base of investments and put more than one or two legs under the metaphorical table.

Some Further reading:


HOW WE SUPPORT CLIENTS

At Aspiire Mortgage Brokers, we assist clients with:

  • Home Loans
  • Investment Loans
  • Debt Consolidation
  • Refinancing
  • Commercial Loans
  • Rapid Debt Reduction strategies