Diploma of Share Trading and Investment
Course Code: 69793

Using leverage to profit

Published on Femail.com.au, October 2010

Statistics indicate that women will generally earn less than men over their lifetime and therefore often retire with less. Statistics also show women tend to borrow less than men and are more likely to own their own home debt free than a man. Is this because women are better money managers than men or are men just bigger risk takers?

The majority of us want to become financially independent, and the reality is that to achieve this somewhere along your investment journey you are going to need to borrow to invest. In borrowing to invest you are in effect bucking the trend, as with the right knowledge and the determination to be different this could be the start of something very rewarding both personally and financially.

My goal throughout this series has been to provide you with the tools to have you well on your way to developing your very own road map to financial independence. In this article I will demonstrate how to use leverage to build your wealth, as I believe the benefits far outweigh the risks when you understand the concept and invest in safe assets that rise in value.

The reality is that only a small percentage of the population actually achieve financial independence because they focus most of their attention on deriving an income from their job to purchase assets that fall in value, rather than acquiring the knowledge to accumulate investments that produce an income. In other words, they work hard for their money instead of allowing their money to work hard for them. If you understand how to make your money work for you by using leverage it can dramatically change your life.

Understanding leverage

In simple terms to leverage means to take a smaller amount of money and gain exposure and control over an asset of much larger value.

The benefit of using other people’s money, or borrowing to invest, is that it increases not only your gains but your ability to build an investment portfolio in shorter time and it allows you to take advantage of investment opportunities when you may not otherwise have the available funds to do so. But just as leveraging can increase your gains, it can also magnify your losses, which is why it is important to understand leverage, your tolerance to risk and have a plan to manage that risk.

Know your options

Perhaps you have already worked out that it would take you a couple of years to build your savings to a level where the returns on your investment would be meaningful and not seem like the slow road to nowhere. You have a couple of options when it comes to building your investment base, including:

1. borrowing against the equity in a residential property, or
2. taking out a margin loan by using cash or shares you already own as collateral

Borrowing against property for investing is like using cash, as you draw cash from your loan to put into an investment. The difference is that like all loans you are required to pay interest on the drawings. Depending on the level of equity you hold in the property, your bank may allow you to use that as security to take out a line of credit (LOC) for typically 80% of the value of the property. A further benefit is that provided you use the loan for investment purposes, the interest payable on the loan is deductible against the income you generate.

If you don’t have a house as your collateral don’t worry as you could choose option 2. A margin loan is similar to a line of credit, however instead of using a property as security this type of loan requires you to put up cash or shares as security (collateral) to get access to more capital. As with borrowing against property, you will pay interest on the margin loan, which is typically set at a slightly higher rate than a LOC. This is because it is generally accepted that the risk you are taking is higher than with the LOC. Therefore, I have a simple rule that says when using a margin loan do not borrow more than the value of the collateral you put up for the loan. For example, if you have $1.00 in cash or shares, you can borrow $1.00 and this gives you an LVR or loan to value ratio of 50/50.

Let’s have a look at a simple example to observe the impact on your capital for both options:

• With a LOC, if you draw down $40,000 on the loan and your investment in the share market falls by 10 per cent, on paper you have lost 10 per cent of your capital, or $4,000 plus the interest paid.
• If instead you have $40,000 in cash and decide to take out a margin loan to leverage your investment you will have $80,000, which is great if your portfolio increases in value by 10 per cent. But if your investment falls by 10 per cent your loss would be $8,000 (not considering interest or dividend income), or 20 per cent of your equity.

This illustrates how losses will be magnified by leverage and is why I highly recommend you get the right knowledge before considering using margin lending. Once you understand the risks involved and you have the knowledge to implement a successful investment strategy you will be able to safely invest in the market with confidence. For now let me show you the power of positive debt and I will demonstrate how to put together a trading plan to assist you in making buying and selling decisions in a forthcoming article.

The power of positive debt

Let’s imagine you now own a home worth $400,000 and you have $200,000 outstanding on a mortgage. Thus, you have $200,000 in equity you could use to leverage other investment opportunities. You decide to take out an interest only loan of $100,000 against the equity in your home for investments. Assuming you are charged interest of 10 per cent per annum to borrow the money, you will be required to pay the bank $10,000 each year. However, the interest payable on the borrowed funds is tax deductible because you are using the money to invest. For the purposes of this example, we will assume your tax rate is 30 per cent.

You decide to invest the $100,000 in solid blue chip stocks that pay an average dividend yield of 4 per cent (fully franked) and your portfolio grows an average of 7 per cent per annum. So what is your net position at the end of the first year?

Figure 1

As shown in Figure 1, even though I used an interest rate as high as 10 per cent and a tax rate as low as 30 per cent in this example, you are still $4,000 better off at the end of the first year using leverage to increase your net wealth. In terms of return, you actually spent $3,000 to receive a capital gain of $7,000 or a 233 per cent return on your investment. Now that’s what I call positive debt.

What’s even more exciting is that your returns get better every year by simply utilising the law of compounding. Let’s take a look at the second year of this investment strategy to see where you would stand. We will assume that the rates of return remain the same but now you are compounding your return on $107,000 invested in blue chip shares.

Figure 2

As you can see in Figure 2, your net position has increased yet again. If we continue compounding our returns, in the third year we would reinvest $114, 490 and receive $8,014.30 in capital growth and $4,579.60 in dividend income. Even when receiving very average returns like 7 per cent, the example demonstrates how powerful the technique of leveraging can be. For as long as you maintain the portfolio, the return will increase assuming you continue to invest in assets that rise in value.

Now you are probably saying ‘what about the $100,000 I still owe the bank, when do I pay that out?’ The point is, the longer you hold onto the portfolio the greater the compounding effect. Eventually, you will reach a point where your investment will pay out your total home loan, if that is your goal. Depending on your tax position and how you have structured your loan repayments, you can achieve this in less than 10 years.

This example is simplistic in that it assumes an average rate of return per annum based on a historical average for the Australian market, taking into account all of the ups and downs along the way. The reality is that in some years the market is likely to experience much higher growth, while there may be one in four years when you do not achieve a positive return, depending on the how the market unfolds. With the right knowledge you can learn how to buy low and sell high to lock in strong gains as well as limiting your downside risk.

The most important point to remember, however, is that as long as the difference between what you own (assets) and what you owe (loans) is increasing you are minimizing your exposure to risk. But I must stress it is critical that you acquire the relevant knowledge and understand how to invest profitably. Then only once you prove to yourself you can be profitable should you consider using leverage as part of your wealth creation strategy. I will also say that it is not as hard or as scary as you might think, all it takes as I mentioned earlier is the right knowledge and the determination to succeed.