At the surface, the idea of leveraged investing is a simple one.
Take out some debt, use it to buy a productive asset, and wait for the moolah to roll in.
But take a closer look, and you will soon realize that most folks think about leveraged investing in very different ways.
As a result, some swear by it – while others swear to stay away from it.
So what exactly is leveraged investing – and should you be using it to accelerate your path to financial independence?
In today’s post, let’s explore a simple mental framework that will help you wrap your head around the concept.
Leveraged Investing – The Basics
Let’s say you’ve got $100k you want to put to work.
To avoid overcomplicating things, you plonk it down into the stock market.
Alternatively, you could also buy some real estate. Being a conservative type, you buy the property outright, with no mortgage.
Whatever it is you choose to do, you then leave it there for 20 years.
For simplicity, let’s assume that the asset you buy appreciates by 8% a year – a reasonable assumption for both stocks [link to magic money machine] and real estate.
On a fine sunny morning two decades later, you wake up, check in on your asset and see that it’s now worth $466k.
Nicely done!
Or is it?
Great Expectations Aspirations
Say you happen to run some basic math and realize that while compounding is indeed awesome, $466k in 20 years just ain’t gonna cut it.
Well, the obvious thing you could do here is to lever up.
I mean, isn’t everyone doing it these days? And it’s not like you are buying crypto on margin (more on this later).
Thus, you decide to use your $100k as collateral to secure a $100k loan.
This can take many forms, including a margin account with your brokerage, or a plain old mortgage if you are buying real estate.
All of a sudden, you’ve got $200k to invest.
Now, you don’t have to be a genius to figure out that at the same return rate of 8%, your investment is going to be worth $932k in 20 years.
At the same time, there’s the pesky question of the $100k loan you’ve taken out way back when and is now due to be repaid.
Assuming a 3% interest rate and a bullet (i.e., end of term) repayment, your liability will have grown to $181k.
You liquidate the asset, pay off the loan – and are left with $752k of equity.
That’s a very nice 61% increase vis-à-vis the $466k in the first scenario above.
But what’s really sweet about this whole situation is that that extra money comes at zero extra cost (or frankly, effort) on your part.
Talk about value creation!
Money For Nothing
Now that you’ve tasted the sweet nectar of making money out of thin air, you obviously don’t want to stop.
50% leverage is something conservative boomers would do, not the brave Robinhood generation!
What if you were to take out a $400k loan against your $100k investment?
Unsurprisingly, the numbers just keep getting better:
Your asset appreciates to $2.3m. There’s a hefty loan of about $700k, but who cares?
After paying off the loan, you’re still left with $1.6m of equity for your troubles.
It’s an absolute no-brainer, you decide. No wonder they say leverage is the key to building wealth:
I mean, why doesn’t everyone do it? And what could possibly go wrong?
As it turns out, plenty.
Air Pocket
The annoying thing about life is that it doesn’t always follow a predictable, upward trajectory – and neither do the financial markets.
And so the real path to wealth is lined with bumps, diversions, and an odd meltdown in asset prices that makes you want to run to your bedroom, hide under the duvet, and pray for the proverbial storm to blow over.
This is exactly what happens in year 10 of your investment. Mr. Market sneezes and all of a sudden, your asset declines in price by 50%.
To say this isn’t enjoyable would be an understatement.
But if you haven’t got any leverage, you kind of feel okay about it.
After all, you know that losing money in the stock market over the long run is near impossible:
As always in the past, the proverbial winds will blow over and the market will roar back with a vengeance.
The problem is that your levered alter ego is unlikely to survive long enough to see the good times return.
This is what happens to your investment portfolio in the event you were 50% levered:
Your asset drops in price to $200k.
Sadly, your liability doesn’t.
Rest assured, that annoying bank of yours will give you a ring with a reminder that you still owe them $134k.
Come hell or high water, they will still want their money back.
Now, if they get all nasty about it and force you to liquidate, you’ll still have about $66k left over.
In other words, the green line on the chart above is still above zero.
Phew. You are wounded, but not defeated.
But what if your leverage was 80% instead of 50%?
Crashing And Burning
We all know where this is going by now:
By virtue of shooting for the stars, you’ve walked straight into a trap.
Your asset is now worth only $500k, but your liability is a whopping $538k.
You are now “underwater” on your investment, with negative equity of $38k.
Time to say goodbye to your asset – and hello to the friendly repo men.
If you could convince them to have some patience, you’d totally make the money back – and then some.
Alas, that’s not how leverage works. Your loan will be called in, assets liquidated (at rock bottom prices) and you’ll end up on the hook for any outstanding amount.
Back To Earth
Therein lies the fundamental challenge with leveraged investing.
It works astoundingly well when the markets are on a tear.
You can double your money in a few months, lever up some more – and keep on going, rinsing and repeating your way to wealth.
But at some point, the music is bound to stop.
And even a short intermission is enough to blow up your portfolio – and take you down along the way.
Leveraged Investing: Rules Of The Road
Now that we’ve illustrated the basic concept, let’s double click on a few important points.
The obvious one is that you should never borrow money at a higher rate than the expected return from your investment.
It’s an absolute no-brainer, and yet I’ve come across folks who did just that – with dire consequences.
Then there’s the fact that the higher volatility of the asset class you are investing in, the higher the chance you’ll get blown out of the water.
Hence, while levered crypto investing may give you an awesome adrenaline rush, it’s also a sure-fire way to lose your shirt.
But the most important aspect is the asset class you are investing in – and the kind of loan you use to finance your investment.
If you are investing in equities, you will most likely use what’s known as a margin loan.
The sucky unfortunate thing about these margin loans is that they are callable.
That is, if the value of your portfolio gets too close to the value of the loan, your lender will demand that you top up your account.
If you don’t, they will liquidate some of your securities.
You don’t have to be an investing genius to realize that selling at the bottom of the market is the worst possible outcome.
Wait a second, you say. But what if I hold some cash in reserve in the event this happens?
Doesn’t that solve the situation?
Sure. But if you have some cash sitting on the sidelines, are you really using leverage in the first place?
Not really. You just paying someone else to use their money – all while your cash is sitting in a zero-yielding savings account.
What about real estate, you ask?
No one can call my mortgage in regardless of what happens in the housing market!
Spot on. Hence, taking out a mortgage to buy a house (or an investment property) is pretty much a staple in western society.
As long as you’ve got enough of a cash reserve to make your mortgage payments, even an interest-only (i.e., a 100%) mortgage can’t blow you up.
The only reason banks (and governments) don’t like the idea of high loan-to-value mortgages is because it leaves you with zero skin in the game.
If things get patchy, you simply walk away, leaving your lender on the hook.
Leveling Up
At this point, the more creative readers might have a clever idea forming in their heads.
If you have a paid-off house, what about taking out a new mortgage against it – and using that money to invest in the stock market?
Best of both worlds, isn’t it?
Well, it kind of is – except that while the idea is indeed clever, it’s certainly far from novel.
What we are essentially talking about here is the advantage of not paying off your mortgage early – and putting your savings into the stock market instead.
In today’s world of near-zero mortgage rates, doing so is one of the worst money moves you can make, at least financially speaking. This is why.
There may be other advantages (peace of mind, anyone?), but that’s a topic for another day.
To wrap it up, leveraged investing is a lot like pouring gasoline on fire (pun intended).
Done properly, it can lead to some spectacular outcomes.
It can also lead to some pretty disastrous consequences.
The good news is that now you’ve got a handy mental framework to assess the risk (and upside) that comes with it.
Thank you for reading – and happy (leveraged) investing!
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So you’re telling me I’m a numpty for paying off my mortgage early during the biggest bull run in history.
Guilty.
Clear and perfectly illustrated as always Mr BoF.
Financially speaking that might not rank on the list of your top money moves 🙂
Tough to quantify the peace of mind you might be getting from being mortgage-free!
Do you have a view on stoozing, in the context of investing. So using 0% rate on a credit card for your spending, and investing the money the credit card has freed up?
How much money would that really free up though?
Isn’t it like a short-term cash advance which you need to repay once the 0% term has expired?
Hi BOF,
A great article as always, leveraged investing in stocks is risky indeed, but hedge funds can’t seem to get enough of it, do they probably think “i’m smart enough to not be under water like normal folks?
And also, 90% of hedge funds won’t outperform the index, so why ultra high net worth individuals still invest their money in a hedge fund? Surely they know it won’t beat the index?
And if you yourself have the chance to put your cash in any hedge fund or private equity company, would you do it instead of good old index fund and leveraged real estate investing? And why?
Thank you
To be honest, I am lost as to why rich folks choose to go with hedge funds.
I certainly would never do so, and I wouldn’t lever up my equity holdings, though I am very happy to use (responsible) leverage in my real estate investments.
As far as hedge funds themselves, they clearly think they can time / beat the market (otherwise they wouldn’t be in the hedge fund business).
Also, there’s the misalignment of incentives. If you run a hedge fund and score a home run, you make out like a bandit.
If you lose money, it’s mostly investors’ money (though the smart ones like the hedge fund managers to have skin in the game)
Mr. BoF, great article. Very timely. I have been thinking about using reasonable leverage to invest in high paying dividend stocks, more like closed end funds like ETV or QYLD. Instead of using margin how about using a low interest HELOC on my house. The HELOC is 3%, QYLD yields ~11% (paid monthly). I can make ~8% on the difference each month. What do you think about that?
I don’t think that’s any different from delaying paying off your mortgage and channeling the extra savings into equities.
However, remember that yields come and go but HELOC payments are always there. In other words, make sure you can cover the HELOC through your regular salary (much like you would for your mortgage payment)
Thanks BoF, another good article 🙂
I have the following assets – is it possible to leverage any of them in the UK? What institution would do that – I guess not a high street bank?
– Vanguard funds in ISA
– Vanguard funds in SIPP
– properties in the EU (no mortgages)
I was trying to do some research earlier, but I could not find any way to borrow using any of these as collateral.
Thanks!
In the UK, margin loans aren’t as popular as they are in the US.
I think Interactive Brokers offer them plus a couple of the private banks
Thus, the most effective way to “borrow to invest” in the UK (as far as equities go) is not to pay off your mortgage early!
Great article as always.
I have no interest in doing this, at least not at scale, but how does this work in the real world? The lender is not going to sit it out for 20 years and then ask for $752K. There are (monthly?) interest payments to be made throughout the term. If you take this out of the asset then that must impact the total return, right?
Totally not done the math, just wanted to leave this comment here before someone else does ?
You are spot on.
In institutional finance, there’s something known as PIK or bullet repayment loans, but that doesn’t happen in retail investing which is what we are talking about here.
Typically, you’d need to make interest payments on your debt and you would probably get some kind of cash yield on your investment.
However, that doesn’t change the fundamental concept of how leverage juices (or endangers!) your returns. Hence, I’ve gone for a simplified representation here to get the points across.
Whilst I’m generally a huge fan of the FIRE community and your blog in particular, fire has generally only been around for a time that coincides with a rising market and I cant help but think there is quite a lot of recency bias in the FIRE movement. Sure in a rising market it makes sense to leverage your primary residence and make returns in the stock market. And yes long term average returns make it look like a no brainer. It’s not risk free though you can end up with a millstone round your neck. This is essentially what happened in Japan in the late 1980s leading to lost decades and that’s a working lifetime for most, so you may not have time to recover. The pre conditions here in the west are now starting to look eerily similar now too so who knows what the future holds. Therefore I’m not sure that not paying off your mortgage is such a good idea. After all it’s the French word for death grip and releasing yourself from that cant be a bad plan. Plus when it comes to leverage I’m reminded of Warren Buffets comment that risking money you need for money you dont need just doesnt make sense. Therefore I think a good test is do you NEED to take the risk, if not then paying off your mortgage can be a very fine plan and go relax and enjoy life, why not, none of us are here forever. Really enjoy the blog as ever, keep up the great posts!
Thanks HF, very thoughtful comment and as you know I’m all for contrarian views on this blog!
The recommendation isn’t necessarily to “not pay off” your mortgage. It’s more about not paying it off early, which is the equivalent of investing at 1-2% (or whatever your mortgage rate happens to be) vs. 8% or whatever you believe the stock market will return going forward.
Sadly, if we end up in a Japan-like scenario, we will all be working well past retirement!
And on a separate note, I fully agree the FIRE movement will shake out significantly once we have a meaningful / prolonged crash or a period of 10 years when it goes sideways like it has in the noughties.
Hi, thanks for the article. A mild way of leveraging against a mortgage could be to call the bank up every five or so years and get the mortgage time period reset back to 30 years. Making the monthly payments smaller, while still allowing a build up of equity. The saving in the monthly payments goes into the market every month. Thoughts?
Yes, I think that’s another way to do it.
So in essence, you are not releasing equity but spreading out the remaining mortgage balance over 30 years over and over again.
Hi BoF
Interested on your thoughts on this situation.
As a self employed individual I am paid gross and pay tax annually. It is possible to change the accounting date for the year end – if that is done it can effectively defer income tax liability for a further 12 months.
I therefore have the potential to leverage the tax funds. How should this be conceptualised?
Also, how should aged debt be thought of? Aged debt represents the sums that are owed now, and will (I hope) be paid in the future. Is it appropriate to ‘leverage’ against those funds, e.g by relying upon them to discharge future IT liabilities.
Perhaps this is one for a separate post! But sure there are lots of contractors in similar positions.
It’s a tricky one.
The easiest way is to invest the funds you’ve got and pay off the tax liability from the new funds you will generate over the next 12 months.
However, given the potential variability in income, it is also a risky path.
If you were to do so, I would at least make sure there’s an open line of credit you can tap to make the tax payment if your earnings dry up for whatever reason.
Does that make sense or did you have something else in mind?
It does make sense. I never usually have a problem getting paid, it just takes time. I suppose in a worst case scenario I could use a form of invoice factoring to realise c. 80% of the aged debt. Or just pay the tax bill late and suck up the penalties and interest.
I am presently relying upon 100% of my aged debt to fund c. 75% of my total tax liabilities (which continue until 2023). I am now wondering whether that is too bullish based on your comment and if I should de-lever. But part of my problem is working out exactly how much I am leveraged. Is it the %of the tax funds that I have ‘borrowed’ (ie the 75%)? Or the % of my total portfolio? This difficulty in conceptualising the situation is not helping me to understand how much risk there is. I think that’s because in most leveraged situations you are borrowing against some form of collateral, whereas here the ‘loan’ is essentially interest free and has no collateral requirement – until it needs to be repaid 100%. So perhaps this is more like stoozing a credit card for 23 months – most people would say that was too short term to be viable.
This is essentially a one-time working capital release (unless your earnings / tax bill continue to grow meaningfully each year)
So I would treat it as a nice boost but equally wouldn’t push it all the way on leverage. Think the issue isn’t as much getting paid but rather what happens if business volumes dip down for whatever reason and making sure you’ve got a sufficient cushion for that scenario.
Thanks for the reply BoF