Investment Leverage Basics - dummies

By David Stevenson

Many investors in the UK already engage in some form of leveraging, borrowing money carefully and diligently – having a mortgage is an example. But you don’t just buy any old house with hundreds of thousands of other people’s pounds. You’re careful with leverage and homes, just as you need to be with an equity or a bond that looks to be equally compelling value.

Leveraging: The theory

In abstract terms, leverage can be defined as the creation of exposure greater in magnitude than the initial cash amount posted to an investment, where leverage is created through borrowing, investing the proceeds from short sales or using of derivatives.

This rather dry definition does remind you that leverage can broadly be understood as any means of increasing expected return or value without increasing your out-of-pocket investment, that is, your money upfront.

With leveraged investing, you take out a loan and make a single large investment purchase on day one. Then you set aside a portion of your income each month to make interest payments on the loan. If all goes to plan, your investment increases in value over time and eventually you can sell the asset, repay the loan and make a handsome profit. At least that’s the plan!

Imagine that you decide to buy a £200,000 house with a £20,000 down payment and a £180,000 mortgage. The £20,000 is your equity investment in the home, and the rest of the purchase price is covered by the lender’s loan of £180,000. If the home’s value increases to £220,000, you’re able to pay back the £180,000 loan and keep the remaining £40,000. You make a 100 per cent return on your £20,000 investment.

Throw interest into the mix and your return is less, but the idea is the same: borrowing lets you increase your return beyond that which would have been possible with your initial investment alone. Without borrowing the £180,000, for example, your initial £20,000 could never have brought you a return of £40,000. In a world without leverage (that is, without loans from friendly, compliant banks!), you’d need to find the full £200,000 in cash. The return on your investment? Just 10 per cent!

Leveraging: The practice

Opponents of investment leveraging maintain that putting other people’s money into housing as an investment (via mortgages) is very, very different from putting borrowed money into stocks. After all, houses only ever increase in value, don’t they?

House prices aren’t that volatile, are they? Well, no! Recent experience shows that house prices can and do fall sharply in value, as do shares. Arguably house price volatility is lower than equity volatility but not by much.

Critics also point out that shares aren’t predictable; they don’t always go up in value. Granted nothing is predictable about risky assets such as shares, but shares (equities) have in the past risen in value quite considerably over the long term..

If that history of positive returns for shares holds true in the future (a big if, of course), why not use leverage to improve your returns, especially if you’re willing to be patient and look to compound your returns.

Compound returns refers to the fact that investment growth accelerates over time as the growth from one year is added to your initial investment to create a larger investment that can grow the next year, and so on. With leveraged investing, you contribute a much larger amount on day one and then hope that the whole amount grows substantially over the long term. The effect of compound returns is much greater with leverage, but so is the risk.

The key to successful compounding is having the largest possible amount growing at the beginning and then leaving it alone for as long as possible.

Tax can also help with leveraging. In some countries, such as the US, you can write off the interest you pay on a loan, that is, it’s tax deductible. In the UK, however, the rules are more complicated. Home buyers may qualify for mortgage interest relief but it applies to only a percentage of the interest paid, is capped at a certain maximum amount and the benefits end after the seventh year.