Leverage is in many ways a dirty word. It shouldn’t be. After all, while many think leverage means going on a trading platform and using multiples of your capital. For example, if you use you use $100 to buy $200 worth of stocks, you will have more skin in the game, more upside but also a lot more risks. Somehow that seems like an unworkable solution to many yet that is what typically happens for real estate.
Buying a $500k house with a $100k downpayment is something most would consider more normal. Why? Is it because real estate prices are more “stable”? Are they more stable for a specific reason or mainly because we don’t get a revised value at the end of every day based on the economy, interest rates, etc? To be clear, i’m not advocating for anyone to take leverage and certainly not to those levels. But leverage should not be a dirty concept.
Otherwise, an investor holding a $500k house with a 400k mortgage and a $300k investment portfolio should only be adding to his stocks investment when that mortgage is fully repaid right?
Using leverage in investing means utilizing borrowed money to increase the potential return of an investment. While it can amplify gains, it also increases the risk of losses. Here’s a balanced look at the benefits and downsides:
Benefits of Using Leverage
Increased Returns: Leverage can significantly increase the potential returns on an investment. If the investment value increases, you earn a higher return on your equity because you’re controlling a larger asset base with a relatively small amount of your own money.
Access to More Capital: Leverage allows investors to access more capital than they would otherwise have, enabling them to make larger investments or diversify their portfolio more than they could with their own funds alone.
Tax Advantages: In some jurisdictions, the interest paid on borrowed money used for investing can be tax-deductible, reducing the overall cost of leverage.
Opportunity for Portfolio Growth: With more capital, investors can take advantage of growth opportunities they might not have been able to afford, potentially accelerating portfolio growth.
Flexibility: Leverage provides flexibility in financial planning and investment strategy, allowing for tactical moves such as short-term trades or hedging strategies that require additional capital.
Downsides of Using Leverage
Magnified Losses: Just as leverage can amplify gains, it can also magnify losses. If the value of the leveraged investment falls, the investor not only loses their equity but still owes the borrowed funds, potentially resulting in losses greater than the initial investment.
Interest Costs: Borrowing to invest means incurring interest expenses. If the investment’s return does not outpace the cost of borrowing, the investor will incur a net loss.
Margin Calls: If the value of a leveraged investment falls below a certain level, the lender may demand additional funds to maintain the position, leading to forced liquidation at unfavorable prices if the investor cannot meet the margin call.
Increased Risk: Leverage introduces higher volatility and risk to a portfolio. The potential for rapid losses can lead to emotional stress and may prompt poor investment decisions under pressure.
Complicated Tax Implications: While there can be tax advantages, leveraging also introduces complexity to tax filings. Poor understanding of these implications can lead to unfavorable tax consequences.
Considering leverage requires a careful assessment of these benefits and downsides, alongside an investor’s risk tolerance, investment horizon, and the cost of borrowing.
TradFi vs DeFi
One area where DeFi (crypto) is much more efficient than traditional finance (TradFi) is collateralized lending. Why? Because you can very easily take an asset (token) you own and pledge it, borrow against it. That makes it much easier to invest with “some leverage”. It does however require discipline and maintenance. Why? Because too much leverage will increase the risk of that position being closed out. For example, if you hold an asset worth $100 and borrow $50 against it to now buy $50 more of that asset, you will now hold a position worth $150 and have a $50 loan against it. A significant decline of that position could put you near a liquidation which happens “automatically” in DeFi.
That being said, I love the idea of being able to take a loan when I see opportunities without filling a form or contacting my banker;) One of many reasons why crypto has a large share of my mind! It’s all about being disciplined in its usage.