Money Monday: How to Leverage Debt to Your Advantage
July 30th, 2012 by Aaron Koo
When Is Debt Bad?
It’s fairly safe to say that accumulating debt for the purpose of impressing a girl on the weekend probably isn’t the most efficient use of debt. However, if that girl were a millionaire and was so impressed with your generosity that she married you and gave you half her wealth, I’d say that was money well spent, wouldn’t you?
If we could cut out the uncontrollable variables and only use debt for the purpose of investing, could you see the minds of people changing?
A Good Way to Use Debt
The idea of leveraging is as old as debt itself. The basic idea is to take on debt to make a purchase that you otherwise wouldn’t have been able to make under your own buying power, like a home or a car. If that purchase pays out dividends or gives you more than you put in, that means paying a premium on the interest is worth it. This is what, in the financial world, people would call leveraging. Let’s look at a more streamlined example.
Borrowing to Invest
Mrs. Leverage just had a talk with her financial advisor and they decided that she was really behind in her savings and needed a boost. The advisor suggested a leverage loan.
The idea is that Mrs. Leverage would take out a loan and invest it in a mutual fund so that she would have the pure growth of that capital without having to save it on a monthly basis. Once you’ve built up the capital you want, you simply pay back the loan. It was weird to her at first. They looked over a few illustrations:
- Amount borrowed: $100,000
- Interest rate on the loan: 3%
- Average rate of return: 8%
- Monthly payments after paying interest only: $248
After 10 years
- Putting $248 into a mutual fund: $27,150 after tax capital
- Putting $248 into a leverage loan: $89,403 after paying back the loan
After 20 years
- Putting $248 into a mutual fund: $78,948 after tax capital
- Putting $248 into a leverage loan: $263,032 after paying back the loan
After 30 years
- Putting $248 into a mutual fund: $178,611 after tax capital
- Putting $248 into a leverage loan: $600,232 after paying back the loan
After 40 years
- Putting $248 into a mutual fund: $371,233 after tax capital
- Putting $248 into a leverage loan: $1,255,102 after paying back the loan
Wowza Is Right!
So debt has a useful application after all. The numbers are quite staggering, if you think about it.
This is such an unintuitive use for debt and yet it’s so very common among billionaires. We can eventually save up for things like a house and a car. However, when investing for the future, ignoring the possibilities of leverage can put you in a position where you’ll never be able to catch up to the potential growth you can get through the proper use of debt.
Tags: debt, investing, money management
Filed under Money.
While leverage has the potential to amplify losses, it also has the ability to amplify losses, which is why it is a very risky form of investing and has to be within the risk tolerance of the individual.
I agree and would also add that many people look at risk very differently. Most business’ are started with a loan from the bank. They took on debt to build up an equity. Many of those people know very little of finance and would apparently have a very low risk tolerance because of that. I feel it would be fair to say that opening a restaurant with borrowed money is far riskier.
Err, amplify gains for the first part.
The ROI must be higher than the cost of credit in order for debt to be profitable.
Don’t forget that the interest payments made on a loan are tax deductible, so even with a 2.5% ROI you will still end up profitable with a #5 interest rate on the line of credit.
Oops, I mean 3% interest on the LOC
I can see where you are going with this Aaron, but I find it hard to leverage debt without the fear of leaving myself completely open to the whole thing collapsing like the stock market. No safety net isn’t something that I am comfortable with when I have 3 kids under 7 years old and I am 53.
My 401k is in funds that bring 3.75-6.75% a year.
Of course Ray, and that’s a great point. As Duane already mentioned, that his strategy is optimal when it’s within the risk tolerance of the investor.
I’m curious, How would a market collapse affect your portfolio?
It wouldn’t have a big affect. I have all but 5% of my portfolio in guaranteed government bonds. The 5% is in High Income return funds. That percentage will not hurt me because I don’t contribute anything to it from my paycheck. I funded that slice of my retirement and have just let it sit there. All my money goes into the safer investment.