Borrowing to Invest: Helpful or Hurtful?

by Nora Dunn on 17 October 2007 20 comments
Photo: Flattop341

Philip's recent article entitled Good Debt Bad Debt sparked quite a debate as to whether any debt can be considered good debt.

And as far as being in debt for luxury items or non-essentials goes, I agree that carrying debt is a bad habit to get into. Interest dollars paid each month are going down the drain to help you pay for items that in many cases have already been consumed.

But to carry debt that enables you to earn money is a concept called Leveraging, and can be very effective in building wealth, businesses, and incomes.

Mechanically speaking, leveraging is the act of using a lever to gain a mechanical advantage or additional power.

Financially speaking, leveraging is similar. Dictionary.com defines it as:

The use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one's investment, to control a much larger investment, or to reduce one's own liability for any loss.

There are a number of ways to leverage your money, some of which you may already utilize:

Home Ownership

This is the most common form of leverage, however it isn't truly a leverage in the same way since you aren't borrowing to earn an income. But in its most basic form you are leveraging your way into your new home with the use of a mortgage.

For simplicity's sake, I'll illustrate the effectiveness of leveraging into home ownership with round numbers. You put $10,000 down on a $100,000 house. This house appreciates in value 2% over the next year. If you were to sell the house after a year, you would walk away with $102,000 (commissions and other erroneous expenses aside). Thus, in one year, you made $2,000 on your initial investment of $10,000. So although the house itself increased in value only 2%, your personal return on investment (ROI) was 20%.

This is a case often used in favour of buying a home as opposed to renting. Not only are you building equity as you pay off your mortgage, but you own and are reaping the benefits of an appreciating asset that would normally be beyond your reach to own outright.

The Down Side: If your home depreciates in value beyond the equity you have managed to accumulate, you could end up in a pickle. I have a friend who purchased a home for $200,000 with $10,000 down, got divorced two years later and had to sell the house. Unfortunately during that time the housing market crashed, and he could only sell the place for $170,000. So taking into consideration his down payment plus equity accumulated in the two years, and subtracting sales commissions eating into his proceeds, he sold the house with nothing to show for it but $25,000 in debt.

Business

If you have dreams of being in business (especially one that involves a storefront of sorts), you usually have to come to grips with the idea of being in debt. To purchase a franchise can cost anywhere from $20,000 to $2,000,000 just to get started. And walking into the franchise office with $2 million in cash is a rare occurrence, indeed.

However business debt is also good debt, as it is a truer form of leverage. You are engaging in the act of borrowing money with the expectation of earning an income, which makes the interest on that loan tax-deductible.

You are also making a down payment on an asset that not only provides you with an income, but also might appreciate capitally.

Similar to above, you invest $10,000 down on a $100,000 business. (This is a very simple example, of course). The business kicks off an income of $10,000/year. You can use this income to help make loan payments, which is a great way of making the debt pay for itself. But depending on the business, you may also find that there is a capital appreciation. For example as you build up a loyal customer base and good reputation, or if you own the underlying property, you may well be able to sell the business for more than the $100,000 you bought it for. This gain on the overall amount can again be expressed as a larger return on your investment of the initial $10,000 plus loan payments.

The Down Side: As with home ownership, if the business goes belly-up and there's nothing to sell, bankruptcy could very well be imminent. This is the inherent risk of owning a business, especially one that requires a capital outlay to get started. There are many tales of business owners losing everything they have, but also just as many about business owners who are earning incomes, plugging away at their loans, building equity in the business, and creating a retirement nest egg in addition to fulfilling a dream. And even a few tales of wild riches achieved with good business investments. Nothing wagered, nothing gained.

Investments

Although investments don't produce an income in the conventional "salaried" sense, many can indeed be income-producing for the purposes of leveraging. And again since you are borrowing money with the intention of earning an income (whether or not you actually do earn income, at least initially), the interest on the loan is tax-deductible.

The appeal behind investment leveraging is best when the interest rates for borrowing are low. For example, you borrow $100,000 with $10,000 down at 4% interest, and turn around to invest that $100,000. The 4% interest is a tax deduction, which means your net interest expense out of pocket is closer to 3%. Your investment then needs to make more than 3%/year in order for the leveraged loan to work out.

If your investment makes 8% or $8,000, and you subtract the $3,000 in net interest expenses, your gain is $5,000. If you express the $5,000 as a return on your investment of $10,000, you just made a 50% return!

The Down Side: Although the gains are magnified with investment leveraging, so too are the losses. If your investment loses 8%, then your net return on investment (taking into account interest paid) is over a loss of over 100%! However investments tend to trend upwards given a long enough time frame (8-10 years at least), so even initial dips in the market can be recouped significantly and the leverage strategy can work. But a long time frame and investment perspective are very necessary ingredients for this recipe to work.

Real Estate Investments

The concept of leveraging into real estate investments is a combination of the Business and Home Ownership strategies of leverage. Similar to the Business strategy, you are borrowing money with the intention of making an income (being rental income). So again the loan interest is tax-deductible. And with the real estate ownership, you are also banking on the appreciation of the asset in question to increase your return on investment.

The Down Side: If you can't find tenants to help you pay the mortgage, then you'll have to come up with the cash somehow yourself. If your resources are tight that might be a stretch. Real Estate market losses are also a risk when it's time to sell.

Risks and Notes to Potential Leverage Candidates:

  • Have extra cash on hand. This is good for covering loan payments when expected income isn't forthcoming.
  • Make it a long term investment. Since both gains and losses are magnified when leveraging, you need to allow a proper time frame for the asset to appreciate and recover from bumps and corrections in the market.
  • Do your due diligence. Meet with your financial planner, real estate agent, or business mentor. Ask people who have leveraged how it has worked for them. You'll find both tales of woe as well as tales of abundance.
  • Go with your gut. Leveraging is risky, no doubt about it. If you are the sort to wake up in the middle of the night in a cold sweat because you're worried about your debt, then you are not a good leverage candidate. You may miss out on some superb returns, but at least you will have your health and a stress-free investment plan.

0
No votes yet
Your rating: None
ShareThis

comments

20 discussions

Add New Comment

CAPTCHA
This test helps prevent automated spam submissions.
Andrea Karim's picture

Wow, Nora, thanks. I'm kind of embarrassed to admit this, but I actually didn't know that that is what "leverage" meant. I love these primer-articles.

Guest's picture
Guest

It might be worth mentioning that much of the cause of the great depression was that people had invested in the stock market using leverage (at the time there was no cap on how much you could do this with, there is now). When the market crashed the banks got nervous and called in the balance of a lot of their outstanding loans -- people had to give just about everything to the banks to pay them off or go into bankruptcy, small businesses collapsed and the worst economic period in US history began. Banks still have the ability to "call in a loan" for whatever reason on most loans. I don't think they would do it on the same large scale again -- but always remember when borrowing money that you affordable monthly payment could turn into a life shattering lump sum if the bank calls it in.

Guest's picture
jtimberman

Borrowing money to invest is stupid, period.

Investing borrowed money is RISKY. There's already enough risk in various types of "investments" that I don't want to introduce the additional risk of borrowed money.

Play the what if game, and you'll see what I'm talking about.

What if you borrow to invest in a single stock, or several single stocks? Day traders do this and lose their shirt all the time.

What if you borrow to invest in real estate, "flipping" houses? People doing this are losing money hand over fist, and this is a big contributor of the subprime meltdown this year.

What if you borrow for your business, to purchase new equipment, or even worse, new product, and you find demand for your services or products has dwindled or disappeared?

Sorry, but borrowing money to invest is just plain stupid. The kind of idea propagated by this particular blog post is teeming with "get rich quick" mentality, and borrowing money to invest is a microwave strategy to making money.

Guest's picture
Guest

Wow, negative Nancy! How do you think any investment bank does it - LEVERAGE!!! The return on investment is much greater, the more money you can put down. If the investment cash flows, it works! Yes, there is a big risk if the business or investment stops cash flowing. But a negative attitude is NOT going to get you that vacation home in the Hamptons (or where ever negative Nancys vacation).

The biggest thing that I think is missed, is that a business or investment ONLY has to pay the debt service. If the loan is on a short enough amortization, you earn large amounts of equity every single year you pay down debt. Therefore, if you have a 10 year am, you own half of the project outright after 5 years - not considering an appreciation in value. So, you sell! Plus, if your entire investment is in property or equipment, you can depreciate it and get a large tax benefit!!!

Debt is not the enemy - improper use of debt is.

Linsey Knerl's picture

This is a well-written article.. thanks for explaining some areas where it would possibly be worth it to borrow.  I would like to point out that your friend (with the divorce) may not be as bad off as it sounds, though.  If $25,000 seems like a loss, remember that she did enjoy use of that home for 2 years minimum.  That's at least what it costs to rent a home for the same period of time.  So while it is a bummer that she lost the home and some cash, she did enjoy use of that home.  We do it all the time when we "throw away" money on rent.  Just a thought.

Andrea Karim's picture

On the flip side, what if you borrow money and invest it in a great stock, make a pile of cash, pay back the loan, and retire rich? There are no absolutes in life.

Nora Dunn's picture

 @Guest: Thank you for this informative addition! You are right, and it does certainly bear repeating that leverage can carry some big risk, and the bank calling in a loan is one of those real (albeit remote) risks.

 @jtimberman: Sure, you could play the what if game, but you could also take it to extremes. Not to say you did, but more to make a point: "What if I go outside and get hit by a bus? Oops - better not go outside today".  It also goes both ways. "What if I don't go outside, and I miss meeting the love of my life today", or "don't buy a winning lottery ticket?"

The matter of risk is all in degrees. For some, borrowing money to fulfill a lifelong dream of owning a business is worth the risk involved. For others, the thrill of borrowing money to invest is exciting, even if it's only $5,000 or $10,000. For these people, the risks are of less consequence than in your picture. It all lies in the eye of the beholder, and is different for everybody.

If you personally don't want the risk, then great. You know yourself well enough to invest in vehicles that yield lower average but safer overall returns. I have known many people who have successfully "gotten rich slowly" with such prowess. But don't press your judgement on others who may not feel that various standard "investment" risk is already too much.

@Linsey: You make a good point about the perceived investment loss of $25,000 being potentially negligible if you consider the cost to rent. However if you also calculate the property tax, repairs, household improvements, and utilities paid in addition to the $25,000 - and it wasn't an expensive city to rent in - then the loss gets bigger.

@Andrea: There are no absolutes in life. Amen, sister!

Guest's picture
Guest

I was unaware that interest on a general loan was tax deductible. Can you point to some information explaining this?

Julie Rains's picture

When Paul wrote about lateral thinking, I couldn't come up with any clever ideas; but I did realize that the wealthy tend to take more risks or rather they see opportunities and are willing to use debt. For example, someone may have the income to buy a second home or vacation home but borrow at low interest rates and then meet the mortgage and other expenses through rental so that positive cash flow is maintained. Then the income can be used for investments that can often return much more than the interest rate of your loan. Great thoughts on leveraging!

I also had the question about tax deductibility of interest. In the U.S., for individuals, interest on loans borrowed against your home (primary mortgages, refinances, home equity loans) is tax-deductible but other types of loans don't offer this benefit. But tax laws vary among countries and the right kind of business structure may allow this benefit as well.

Guest's picture
Guest

Nora,

I know this is a primer article and you as trying to give some simple examples but I still think the ones you do give are lacking. Let me explain using your example above:

I took out a $100,000 loan at 4% interest and within a year I make 8% back on my money. First of all, I didn't think that a personal loan was tax deductible so that means my 4% loan really is 4%! Anyways, my rate of return is 8% - 4% = 4% or $4,000 after one year. However, I'm subject to regular income tax because of the short term. Let's say I get taxed at 33%, which is equal to $1,320 of my $4,000 gain. That leaves me with a profit of $2,680 after everything is said and done. So much for my 50% return!

Just keep that in mind when leveraging. Sure you can make a lot of money, but you can also lose a lot as well. It's all about your own personal tolerance for risk.

By the way, I wish I could find a 4% interest rate for a loan. They're more like 7%-8% which would completely eliminate your gain.

Guest's picture
Lex

Interest can be tax deductible on general loans if they're used to buy something that will generate dividends, royalties, annuities, or interest (See Passive Activity Loss for more information). There are several qualifications to deduct interest paid on monies borrowed to buy such items and you should probably consult a tax professional to ensure that you're going to meet all the qualifications if you decide to do it.

That being said, I still think it's foolish to borrow money to invest. Contrary to popular belief, there really is no such thing as a "sure thing" when it comes to investments. There's alway the possibility of loss, and when you discuss leveraging you also need to take into account risk. The amount of risk involves actually becomes a factor in your potential profit. So if you think there's a potential to make 10%, but there's significant risk, then statistically you would discover that in an average case you'll lose money despite the potential 10%.

There are some that can actually borrow money to invest and make money most of the time, but for the vast majority of people (especially laymen) I would tend to think that you'll get burned more often than not.

Guest's picture
KCLau

I think it is about the risk that involved. When we are investing with own money, the risk is to just lose what we've invested. If we are borrowing money to invest, it is like using our future income to invest. We might earn more, but on the other side, we are putting our future income at risk.

Guest's picture
kweeket

@Linsey Knerl

"If $25,000 seems like a loss, remember that she did enjoy use of that home for 2 years minimum. That's at least what it costs to rent a home for the same period of time."

That would be true if rent prices had been keeping pace with home prices, but they haven't - at least not where I live. In Seattle, I pay $320/month for my portion of rent. To buy the same size apartment in a similar neighborhood, I would pay upwards of $1,100/month towards my half of the mortgage.

Guest's picture
Guest

But that's your PORTION of the rent. If you rented a house entirely to yourself, you'd be paying at least $1100 in Seattle to rent a home, if not more. Apples to apples.

Nora Dunn's picture
Nora Dunn

Awesome comments, guys! I appreciate all the feedback. As is evidenced by this comment string, risk is very different for everybody, and quite a hot topic. I won't try to candy-coat the risk involved with leveraging....it's risky! I simply want people to know it is a strategy for businesses and wealth accumulation for people with stong stomachs.

re Interest Deductibility: Lex gave us a link about interest deductions for investments, and here is one for business investments. The relevant text on the page for eligible business deductions reads:

Interest - Business interest expense is an amount charged for the use of money you borrowed for business activities.

@Guest (Not Entirely Accurate); You are right....I didn't delve into the taxation of the income, which in turn reduces effective returns. I felt it was beyond the scope of the article, but it is still relevant information nonetheless.

And in regards to the interest rates used, you're also right; the higher the interest rate the less appealling the strategy gets. I was using extremely simplistic numbers for the example just to illustrate the point.

But even using your numbers with an after-tax return of $2,680 on the initial $10,000 investment, you have a 26% return! I still think that's pretty good for suitable leverage candidates.

@Lex: Thanks for the link for interest deductibility on investment loans. You mention at the end that you feel that the vast majority (especially laymen) would get burned more often than not. I agree! Leverage is not for laymen looking for a cheap thrill. People who leverage are knowledgeable, and surround themselves with experts: accountants, business coaches, and financial planners. I would never expect that a DIYer could jump right into leveraging....just look at the number of knowledgeable people on this comment string who didn't know that interest on business and investment loans can be tax deductible! (mind you, it's not always tax-deductible.....that is a matter for the fine print in tax law). It is through the use and knowledge of experts that we can get ahead in life. It's too hard to do it all by yourself.

Guest's picture
kweeket

@Guest

I think you missed the part where I said $1100 was HALF of what it would cost to own a house. I pay half of the total rent, so I also assumed I would pay only half of the mortgage payment. If I owned the house alone, I would pay upwards of $2,200, and if I rented alone I would pay $630.

I'm not saying owning is a bad idea - on the contrary, there are many great reasons to buy - but when the rent/mortgage payment ratio is so skewed, it's not true that you necessarily save money by owning rather than renting.

Guest's picture
Ermos

I would first like to address some observations that I have noticed within my circle of friends.

The guy who "usually" says that debt is always bad, is the same guy that has credit card debt at 18% because he buys every gadget as soon as it comes out.

That is foolish. The interest is high and non deductible. Meanwhile the assets that he purchased with that debt is depreciating at a rapid rate.

The guy who "usually" says that debt can work to your advantage is the guy who has zero credit card debt but will borrow to invest.

Allow me to put forth an idea. The stock markets over the long term generally perform at about 10% per year. No major index outside of the Nikkei has ever had a negative 10 year return. EVER! What if you built a well diversified portfolio. Either 10 mutual funds that cover everything from small cap to large cap. US, Europe, Asia, Emerging markets etc. Or if you prefer stocks, you need to be in at least 100 stocks. Mostly blue chip and preferrably ones that pay dividends.

If you are invested in companies such as big banks, WalMart, McDonalds, Proctor and Gamble, I would argue that you couldn't lose money even if you tried. These companies are huge with enormous revenue and are essentially recession proof.

Even being conservative, lets say we average only 8% annual returns for 20 years. Lets say we borrowed $100,000 at 6% and paid interest only. The payments would be $6,000 per year. Over 20 years the cost would be $120,000. However, if we factor in the tax refunds that we get from the leverage (lets say 33% tax rate) we would get back $40,000. Net cost out of pocket over the 20 years would be $80,000.

Our investment would grow to $466,000. After we pay back the bank it's $100,000, we are still left with $366,000. Even if we factor in $66,000 of taxes, we are still up $300,000 net of taxes. If we get 10%, our net profit would be $500,000.

Long story short, as long as you don't get greedy, you can really limit your down side while still benefiting from a leverage.

The best I have seen thus far is a guy named Talbot Stevens. Do a search on him. He has a strategy of leveraging conservatively.

Someone already made a great point. Debt is not bad. Debt is bad if used irresponsibly.

Myscha Theriault's picture

I really think it's about picking the right investment up front and being able to cover certain bumps in the road by maintaining adequate levels of liquidity. Most of my research on this has been in real estate, so I'm not as comfortable doing the leveraging thing in the stock market as some others might be. But it's all in where your knowledge base lies.

I think the primer articles are a great idea! I'm thinking of putting one together on hard money loaning as it relates to real estate.

Guest's picture
wander

I think there is something not so clear on this article. What I know is you can deduct tax up to 100% up your home value. Say, you put down $10000 for a $100000 house, you can turn around and borrow 125% of the home value meaning $12500 - $100000 = $35000; however, your house value is only $10000 more than original debt, you can only deduct $10000. Sound interesting, but you cannot do it. How can you put down $10000 to buy a house and then turn around to borrow $100000? It is not quite true.
Besides, there are all kind of costs for the equity loan to consider, including appraisal, .... Should I borrow it anyway? Maybe not. Simply too risky.

Below is the link for your reference:

http://www.bankrate.com/brm/news/loan/19990203.asp

Guest's picture
Guest

I dislike borrowing money to make money.
However, as a average working American on today wages.... Is there any other way to to come out ahead. To work for cash these days seens to be a losing battle on all fronts reguardless of your income level.
The real problem here is not looking at the whole money pie.
Understand these elements before you begin to leverage anything.
1) If you borrow money , invest it , make a nice return.... you are wrong to thing you are ahead of the game if you have one creditcard in your bag. Those interest fee will kill any profits. Those tempations to spent are to great to control by anyone.
2) If you drive a big car , your car payments, insurance, repair costs , registration and gas destroys your future money gains . Every vechicle cost more than it is worth. Every vechicle creates emergencies no one is cash ready for.
3)If you leverage realestate , make a nice profit... you must deducts all your loses which includes taxes, mortgage interest, repairs, and a host of other expensive items.
Yes, most of us need to owe a house, car or creditcard to live in the modern world. But the more you go after borrowing money to make money you will soon discover that its a different merry-go-around just like the working income trap.
You will always beleive more cash is the way to go. Soon you too will be overextended in outgoing money instead of your incoming money.
Balance is the real issue here... just know no gov't in the world has ever acheive money balance and few people will acheive it in their lifetime.
Beware of your wants as oppose to your needs.
Leveraging money is just one more balancing act to stay upright in the cash arena!