Importance of Leverage

One mistake I made in my 20’s when I started investing was having a strong aversion to debt. While I was comfortable being 100% invested in equities I wasn’t comfortable leveraging my investments. I also made it a priority to pay off my mortgage. Which in retrospect wasn’t the optimal way to use my extra cash. As I got into my early 30’s I realized that although it’s far from a fatal mistake investors should be actively using leverage from as soon as they can responsibly afford to. Which in my case would have been around age 24. I was a little late to the game and didn’t start borrowing to invest until my early thirties.

There are multiple benefits to using debt to invest. The first being the tax advantages. If you borrow money to invest in either real estate or stocks/bonds than the interest paid on the investment loan is a tax deduction. You do have to be careful though because any stocks/bonds that you purchase with an investment loan have to generate income such as dividends or interest or have a “reasonable” expectation that they will generate income. So basically, you have to buy stocks that pay a dividend, you can’t buy momentum stocks, small mining stocks, or high flying tech companies. Well you can buy them you just won’t be able to write off the interest.

The second benefit is that if you start using leverage at a young age you can take advantage of the 8th wonder of the world - compounding interest. You can basically use other people’s money to start rolling your own snowball of wealth.

Here’s an example of how you can use leverage to buy a rental unit with no money down. Basically if you want to buy a rental property you need to come up with 35% of your own money, the bank will lend you the other 65% secured against your rental property. Now theoretically if you’ve done your homework the cash flow from your tenants should be sufficient to pay your mortgage/expenses and still leave some money in your pockets every month.  Now if you have any equity in your primary residence you could take out a HELOC (home equity line of credit) and use that to fund the 35% down payment. So really you could buy the rental with no out of pocket money, have your tenants pay the expenses/mortgage and at the same time you can deduct the interest.

Now before you go out and leverage yourself up to your eyeballs it’s important to understand that although leverage can multiply your gains it also has the potential to multiply your losses. If used incorrectly leverage can be a dangerous thing. That’s why I think it’s very important to perform a financial stress test before increasing your leverage ratio. Here are some what if scenarios that you might want to model before taking on any leverage:

1. What would happen if interest rates rose by 1%, 2%, 3% etc.
2. What if my dividends were slashed by 10%, 15% etc..
3. How many months could I afford to have my rental vacant?
4. What if I or my spouse lost their job? How would that affect my leverage position?
5. Most importantly am I going to be able to sleep at night knowing how much money I owe?

Another option is to ladder your debt. If you felt that you were comfortable investing $100,000 of borrowed money you could deploy that capital over 4 years ($25,000) a year. This could help smooth the ride. It would also let you dip your feet in the water and ensure you’re comfortable with a strategy before going all in.

Do you use leverage? Comments welcome.