Leveraging With Investment Loans Increases Your Financial Potential

Potentially higher returns but greater risk!

Investment loans or equity loans, often referred to as leveraging (or gearing) are a form of borrowing in order to invest a greater sum than might otherwise be possible.

The loan proceeds are invested with the intent to earn a greater rate of return than the cost of interest on the loan.

However, good debt advice is to not engage in this activity until sufficient experience has been gained.


Company Leveraging

Gearing is employed both by individual investors and by companies. Borrowing by companies against an asset or assets, providing it is nor excessive, can provide some advantage if the funds are used to good effect.

If a company's return on assets (ROA) is higher than the interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow.

On the other hand, if the company's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow.

A company's debt to equity ratio is an indication of its leverage - that is, how indebted it is.


Individual Investor Leveraging

Portfolio loans taken out by an individual investor (gearing a portfolio) allows a greater potential for maximizing shareholder wealth than otherwise would have been available.

The potential for loss is also greater and therefore the investment risk.

If the investment becomes worthless, not only is the invested money lost, but the loan still needs to be repaid.

Using portfolio loans or margin lending is a common means of investment leveraging for individuals. The value of the portfolio is commonly used as collateral for the margin loan.

Derivatives allow individuals to gear without borrowing explicitly, though the 'effect' of borrowing is implicit in the cost of the derivative.


Options

Buying a futures contract magnifies an investor's exposure with little money down. Options do the same.

The purchase of a call option on a security gives the buyer the right to purchase the underlying security at a given price in the future.

If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security.

However, if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument.


Contracts For Difference and Warrants

Contracts for difference, or CFDs, are also a derivative product that allows you to bet on the movement in the price of an underlying security such as shares. Like other derivatives, CFDs do not entitle you to physical ownership of the underlying share.

A warrant is a derivative security that gives the holder the right to purchase securities (usually shares) from the issuer at a specific price within a certain time frame.

The main difference between warrants and call options is that warrants are issued and guaranteed by the company, whereas options are stock-exchange instruments and are not issued by the company.

Also, the lifetime of a warrant is often measured in years, while the lifetime of a typical option is measured in months.

Investment loans may also be required to be taken out when considering capital-protected products. This form of investment allows investors to protect the downside (at a cost) and participate in any upside in equity investments.

In situations when the stock market appears to be overvalued, short selling some stocks may appear to be a sensible strategy.

This normally involves borrowing shares in order to short sell them and may also involve an investment loan or margin loan.


To Conclude

Leveraging profits in shares, whether through margin or investment loans, or through a derivative security amplifies the potential gain from the investment, but also increases the potential loss.

This particularly relates to situations like the 1987 and 2007 stock market crashes where the market lost 25 to 30% or more of its value. Being able to manage stock market crashes is an important means of leveraging your financial potential, with or without loans.

A great deal of caution needs to be exercised if using these financial products in conjunction with a share portfolio.

I sometimes use a margin loan but not any derivative products. I keep any loan to less than half what the lender offers in order to have a sufficient buffer against margin calls.

I would never use my home as collateral for a margin loan.

Investment loans do have advantages when value investing in order to pick up stock in profitable companies at cheap prices after a market crash.

The loan can then be reduced or paid off as the stock price improves and some of the stock is sold ... but good debt advice when considering an investment loan is to proceed with caution.

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Related Articles

Portfolio loans - or margin loans use the equity in your share portfolio as collateral for the loan. How big a loan should you have?

Capital-protected products - provide higher protection but at a greater cost. Check out their characteristics.

Debt management - to me means keeping my eye on the key measures of debt to equity ratio and the interest coverage ratio.

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