Mastering Leverage – Part Three

In this blog series, we're exploring how you can you use leverage to build your finances.

Consider Financial Leverage, but be Careful

By far the most common form of financial leverage is mortgaging for investment property purchase. The benefit of property is that it is tangible; you can stand inside a property and run your hand along the walls – it’s physical, and that’s why it’s the easiest form of leverage to get.

There’s little risk to the lender when their money is secured on a physical property and they can take it off you at any time. I don’t invest in property myself, but I’m certainly not averse to the idea. And let’s face it, it’ll take you a long time to save up enough to buy an investment property outright, so borrowing makes sense. Just be aware of these factors:

I suggest you reduce your risk as you go along by using the income received by any investment property you have to reduce the loan outstanding. Most Buy-to-Let investors take out interest-only loans and don’t pay them down, Instead, they rely on increasing property prices to free up more equity which they then borrow against to continually increase their portfolio.

Their first property goes up in value, they borrow more to release a deposit for the next house, they borrow more to buy that one. That’s all fine, but please don’t over-leverage yourself. I’d recommend paying down the debt as you go along.

Financially, that may not stack up. Money is still relatively cheap, so it might make sense to keep borrowing, and keep leveraging, but don’t overdo it. Potential clients have come to me with million-pound property and the same amount of debt.

It’s all very well if on paper you have half a million quid worth of equity, but releasing equity means that you need to sell houses, and that might not come as easily as you think and it always incurs costs, often significant. If you’re going to be a property investor – go slowly. Build slowly and carefully, and try to keep a very healthy debt:equity ratio.

Let’s consider another example. You own your own home worth £500,000 and you have a mortgage of just £50,000 on it. You discover that you can borrow another £250,000 on your home mortgage at a really low interest rate – call it 2.5% fixed for five years. Should you borrow that money and invest it in the stock market?

Mathematically, it makes sense. You can probably get an average of 6-7% per year if you invest reasonably aggressively. But you know that this return won’t come in a straight line, and that markets are volatile.

Assuming you can afford the repayments on the higher mortgage, you could put that money to good use. Assuming you keep your job so that you can continue repaying the mortgage and that you invest in liquid, easily-sellable investments, then this strategy makes sense on paper. If using leverage effectively is about investing wisely and managing downside risk, how does that work in this example?

Well, I’d be investing that borrowed money in super-low-cost funds, so I’m not throwing money away on costs. I’d consider using any yield I had to reduce the debt as I went along. And for sure I’d be taking out income protection insurance so I know I could pay the mortgage if I couldn’t work.

Imagine the difficulty I could get into if I had to quit work due to illness and markets happened to be down at the same time? The investments could be worth less than I’d borrowed at that point, so I wouldn’t want to sell them down, but I might have to if I no longer had a salary. I’d also be keeping a very close eye on any tax liability I might have if the investments rose.

If the maths works out, and if you have managed the downside risk, then this is something I would definitely consider, but I reckon only a few out of every thousand people should consider this in practice.

Be careful – consider the downsides of borrowing to invest in any form, property or otherwise. Make provision to manage the downsides and if the maths still stacks up AND if you have the temperament that means you won’t lose sleep over this, then don’t discount financial leverage.

As with everything financial, it’s important to be intentional about such things. Here’s a quick checklist to see whether financial leverage might work for you:

• Does the maths stack up? That is, can you borrow at a lower rate than the likely growth of the asset you want to buy?
• Can you use the yield/returns form the investment to reduce the debt over time?
• Can you cope with the added risk that leverage brings in return for the added growth?
• Can you mitigate the downside risk in some way, for example by taking out some insurance?
• Can you unwind the position relatively quickly without cost/tax implications?
• Is the proposed borrowing and investment a reasonable proportion of your whole wealth?

If that answer to all or most of these is yes, then do consider financial leverage to accelerate your wealth-building. If not, then you should probably steer clear.

If you missed part two in this series, you can find it here. Otherwise, click to keep going.