Borrowing to Invest

Borrowing to invest is often demonised in the financial press. It is referred to as ‘leverage’ and for good reason, it ‘levers’ up your gains and losses. The only time the leverage has no apparent effect is when the return is the same as the cost of the leveraged capital. Recent examples to demonstrate the potential effects of leverage (I will use the rate from a Line-of-Credit I have operated over the periods in question, you may have been able to borrow at higher or lower rates yourself):

1. On 30 November 2007, you decided to borrow $100,000, in order to purchase an investment in the S&P ASX200 (TR) indices. In the ensuing 3 years to 30 November 2010, the annualised return has been -7.01% pa, which means your original capital is now worth $80,409.76. During this period, at your average of 6.8648% borrowing costs, you also paid $20,594.40 in interest costs. When you subtract your borrowing costs from your remaining capital, you are left with $59,815.36, which implies an annualised return of -15.74%. Your negative result has been amplified considerably more than the -13.8748% loss indicated by the difference sum of the borrowing costs and the negative growth.
2. Fortunately, 10 years ago, on November 30 2000, you decided to do the same thing. Your annualised return has been 7.8% pa, which means your original capital is now worth $212,012.31. During this period, at your average of 6.6302% borrowing costs, you also paid $66,302 in interest costs. When you subtract your borrowing costs from your remaining capital, you are left with $145,710.31, which implies an annualised return of 3.84%. Your positive result has been amplified substantially, instead of capturing the 1.1698% (difference between interest costs and earnings rate).

Both of these periods, we must bear in mind cover the worst market period in living memory (unless you’re really, really old…). The other thing that is left out of the calculation is the ‘negative gearing’. In simple terms, in relation to the examples above, assuming you were in the 38% tax bracket, this effectively means that the government effectively covers 38% of your borrowing costs by virtue of tax you will not pay due to your annual income being reduced by the interest charges produced by the borrowed sum.

In the case of the second example above, when we strip out the $25,194.76 of borrowing costs the government effectively pays; you are left with $170,905.07 after paying ‘your share’ of the interest. Your new annualised return is 5.51% pa, which is about 4.7x the 1.1698% difference between the borrowing costs and the investment return.

There are two key mistakes people make when borrowing to invest. The first is the wrong type of borrowing. Margin lending, for example, is fraught with risk, if your holding declines below a certain point, your shares can start to be sold out from under you. Shares are volatile, as Warren Buffett says ‘Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.’ If you use margin lending, the choice may not be yours. Unless you can borrow against an asset, and are confident that even in the event of a downturn, you will be able to service the debt, then ‘leverage’ is not for you.

The second mistake people make is timing. If I met someone with $500,000 of available equity to borrow against, say in their home, I would strongly advise against borrowing the whole sum right now and investing it all. This is despite my opinion that the market over the next 5 years is likely to perform equal to or better that historic averages. More prudent in my opinion would be to set up a strategy, whereby each month over a 4-year period, about $10,000 was invested monthly, this will enable the investee to ‘dollar-cost average’ their purchase and ensure they build their holding at a price that will evenly reflect the market average price over the period.

Borrowing to invest is a reasonable strategy, provided you are cautious and bear in mind these types of issues, and remember, the higher your tax rate, the more viable the strategy is. A taxpayer in the 45% tax bracket, who can borrow at 10% pa over a period, needs only be confident that their investment will grow by more than 5.5% per annum to justify the investment. Compare this to an individual in the 15% tax bracket, who would need to be assured of at least an 8.5% return to end in positive territory. Tony Hansen 08/12/10