The Value and Risks of Leveraging

by Scott Rawkins

Leveraging to invest is a double bladed sword and using it properly can help you cut your way to financial freedom and using it carelessly can leave a bloody financial mess. The value of leveraging can be most simply stated as the benefit of using other people’s money. By borrowing the funds you need to invest and gaining a return you essentially gain the spread between your borrowing costs and your investment gain with no personal investment, some people coin this infinite return. On the other hand, should your investment return be less rosie and you end up less in assets then you borrowed, or a complete loss, you still must repay the debt and the cost of borrowing, not an infinite loss but not a pretty picture.

In the investing marketplace, whether this be real estate, stocks and bonds, mutual funds or another investment vehicle it is a common saying that risk equals reward. That is to say the more volatile or risky investment you choose the more potential gain you may make. It is also a common piece of advice to try and understand how long you wish to invest for before investing to give your investment the time it needs to grow. When considering leveraging, it is important to consider these factors well, perhaps even more closely then when you are not borrowing money to invest. Prudent investing is not only choosing an investment that earns you a return, it is also choosing an investment that you can be comfortable with, an investment in which your asset will be given the time it needs to grow and whether the highs and lows which are present in any investment cycle. Many investors misunderstand their asset choice or their own personal tolerance for risk. If your investment gains 10% 3 years in a row, you are a content investor, you feel your choice was a good one, however should it lose 20% in one year many investors lack the tolerance for such risk but are unaware of this until it happens to them. Leveraging is a great opportunity for return, however your tolerance for risk must be higher than normal. This is because in that year where your investment loses, you can withdraw if you want but you still must pay the cost of borrowing your funds.

Quickly, leveraging is commonly done in a few situations; buying a home, purchasing some RRSPs at tax time, and/or using a margin account to buy stocks and bonds. The basics are simple, you borrow money from the bank and use it to invest in a home (this is a mortgage of course), in some RRSP investments (people do this all the time to reduce their tax burden), or you are stock market investor and you have access to funds in your account to purchase without cash. The strengths of this strategy are fantastic. You would otherwise not have had the funds to invest in the asset you buy. For example, almost all people who buy their first home would never save enough money to purchase it with cash. Leveraging is the only way into home ownership for most. The second is your gain in your investment took much less or possibly none of your own funds. If you have a successful investment which results in a large gain for you, you simply pay the cost of what you borrowed and you have just created wealth seemingly out of nothing. I have heard real estate investors call this infinite return. If done wisely and with enough patience you can truly use a leveraging strategy to create wealth from a lesser sum of funds than if you did not leverage. An essential truth of investing cannot be ignored however, where there is a great reward there is an equally great risk.

The disadvantage of leveraging is simple. If your return is not present or not being realized yet you still have to cover the cost of the debt. If you suddenly need to redeem your asset you still have to cover the cost of borrowing (the interest) and the amount of money you originally borrowed (the principle). You have essentially doubled your risk, the risk of losing your investment exists (although usually not all of your investment) and the risk of having to pay the cost of borrowing and the principal back is also there. To leverage you need to have other resources to fall back on besides the assets your are buying. Examples of this are easy to see. The homeowner buys a home with the intention to renovate and flip the home, takes on a mortgage payment and the real estate market dips, they now have to wait patiently until the market recovers while paying their mortgage payment, their time horizon must be long enough for this to happen, they must have other resources to whether the storm. The RRSP investor takes out a line of credit with the bank to purchase some Mutual funds or other RRSP investment. They enjoy a tax deferment however the stock market dips and they are forced to pay the interest on the line of credit until such time as they can repay the debt. It is not to be taken lightly, on the other hand with prudence and planning, understanding of oneself as an investor, and understanding of the investment and how it functions, leveraging can be an excellent tool to using your resources very effectively.

In closing, the power of leveraging is vast, the ability to purchase real estate, reduce your tax burden or realize gains with little or no of your own funds invested is a remarkable tool in planning your financial future. This style of investing has numerous applications. The best way to pursue it is by consulting an advisor and undergoing a review of your financial situation, your tolerance for risk, your assets and liabilities and your most importantly your goals and your time line for accomplishing those goals. It is these goals we all live for and invest to succeed in accomplishing. Be careful to consider each swing of the blade lest it cut you and leave you wounded and obstacles more numerous, use leveraging wisely as a blade to chop obstacles free of your path to financial freedom.

Scott Rawkins, Mortgage Broker
Dominion Lending Centres
Total Mortgage and Leasing

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  • Joel

    Hey Alain, thanks for the newsletter :). Very informative!

  • I agree with you Scott. Leveraging if done carefully can be a very important tool to accelerating your wealth. Investments such as real estate that provide cash flow and that are in areas with strong economic fundamentals can provide solid long term growth with the benefit of having your tenants pay off your mortgage. Even if the debt on your investment property never went down, inflation will erode your debt over time. Think about your parents house that they bought 25 years ago for $40,000 with a HUGE 75% loan to value of $30,000. If they never paid off a cent of that, do you think they would be unhappy today with a dept of $30,000 on a $1,000,000 house? See my article on how the rich make money from borrowing