Debt will have a dramatic effect on your investment returns.
Remember, investing is all about risk versus reward. We want to focus on the reward, but we need to always consider the risk of loss, both of money and of time. In no scenario is this more important to consider than when adding in leverage, or debt, to your investment portfolio. I generally define personal investing as putting savings to work. You obtain savings through hard work, patience, and discipline. Borrowing money did not take hard work, patience, or discipline. Investing borrowed money is fine if you know what you are doing, but for most investors is should be considered the equivalent of gambling.
Leverage can be a good thing
First off, here is the positive of investing borrowed money. Let’s say you have $10,000 in cash and you want to purchase real estate because you have been told that it is the secret to building wealth. But where can you buy real estate for $10,000? No problem, your realtor says, we’ll use the $10,000 as a down payment on a $100,000 condo and the rent will more than pay for the mortgage payments. The biggest selling point of using leverage is its effect on your rate of return. Let’s say the rent covers all expenses so you are breaking even every month. Why are you investing in something that makes no profit? Because you are counting on the value of the real estate to increase. Take a look: A $10,000 cash investment increases by 10%, you’ve made $1,000 or a 10% rate of return. If you leveraged, though, and purchased a $100,000 property which increase by 10%, you’ve made $10,000. Your original investment was only $10,000, so your rate of return is 100%. So why wouldn’t you do this? The problem with leverage is that while it can magnify your returns, it will also magnify your losses. Run the same math with a 10% loss. A 10% decline in a cash investment represents a $1,000 loss, but you still have $9,000 of your original investment. A 10% loss on the $100,000 is $10,000. But you still have $90,000 right? No, you owe the bank $90,000, you have nothing.
Margin callsIn the case of real estate, as long as you can continue to rent your condo out, you should be fine. But, if you borrow funds in a similar manner to purchase other investments, you can get yourself into a lot of trouble. Stock brokerage firms, for example, make a lot of money by extending credit to their customers in the form of margin. Simply put, they will give you a temporary loan with which you can purchase stock, but they charge you interest on that loan. Using margin works well when the market goes up, but can cause real headaches when the market goes down.
Here is how it works. If you have $10,000 to invest, your broker may extend an offer to allow you up to 50% margin. In other words, they are offering to loan you money. Let’s say your purchase 200 shares of a stock valued at $100 per share – $20,000 in stock. $10,000 was your cash, and $10,000 is the brokerage loan, you are now at 50% margin because 50% of your portfolio is loan balance. Here’s the problem. Let’s say the share price of the stock drops by 20% down to $80. Now your portfolio is only worth $16,000. 50% margin is $8,000, but you owe the brokerage $10,000! The broker now has the right to demand that you bring your account into compliance by forcing you to either deposit an additional $2,000 or sell stock at the worst possible time and realize losses on a position that is probably only down temporarily.