Build Wealth: Profit from Leverage

Borrowing to invest can be an effective way to build wealth. But it's important to understand the risks as well as the rewards. Just because you can afford to pay cash to purchase an investment doesn't mean you should. You may want to preserve your capital to use for other purposes, or you may want to borrow funds in order to benefit from the affects of leveraging. This can be a very effective strategy. However, it's not for everyone.

In some ways, leveraging turns traditional investing on its head. For example, a typical investor might contribute $200 to his or her portfolio and watch it grow gradually. An investor using leverage, on the other hand, might borrow $25,000, invest all of it right away, and then pay the loan back over 15 years at $200 a month. This strategy is riskier, but it's potentially more rewarding.

What are the benefits of leveraging?
People who borrow to invest do so for two main reasons. The first is to magnify the effect of compound interest by having the largest amount of money invested for the longest possible time. Investors who start from zero and save $200 month will have to wait several years before their portfolios really begin to snowball. By borrowing $25,000 and being "fully invested" from day one, a leveraged investor can potentially start earning considerably greater returns immediately.

Of course, this is assuming the chosen investments appreciate in value. Also, the returns will be offset by the amount of interest being paid on the loan. But over the long term, leveraging may still pay off even if the investment returns are less than the interest rate on the loan. This is due to the other benefit of leveraged investing: The possible tax savings. For example, a popular way to use leverage is to take out a home equity loan. Because this is a type of mortgage, the interest you pay may be tax deductible, which can significantly reduce the cost of borrowing.

What are the risks?
It's critical to understand that the same characteristics that make leveraging potentially profitable also make it more risky. Just as your returns will be magnified, any losses will also be correspondingly greater.

If you invest $25,000 of your own money and your portfolio drops in value to $15,000, after 15 years, you've lost $10,000. But if you borrowed $25,000 to purchase that same portfolio, you're out of pocket much more. If, for example, you paid for your investment by taking out a home equity loan with a 15-year term at 6.5 percent, you'll also have paid $14,200 in interest. Bottom line: Your total loss is $24,200 ($10,000 + $14,200) -- almost 150 percent more.

Using an adjustable rate home equity loan to invest also means that any time interest rates rise, your cost of borrowing will increase. Sometimes your investment returns will go up to compensate, but sometimes they won't. In addition, some loans may be subject to a "margin call." This means the lender can require you to pay back the loan principal in full at any time, possibly forcing you to sell your investments at a loss and to find another source of funds to make up the difference. In a worst-case scenario, if you can't afford to pay back the loan, you could even lose your home.

Who is leveraging right for?
Leveraging is a strategy best suited to affluent, experienced investors. You need to have the excellent credit necessary to qualify for a low-interest loan and the knowledge needed to make wise investment choices. You must also be able to absorb any potential losses that can come with this strategy.

You don't have to be wealthy to use leverage, but you must have a healthy cash flow. You should be able to comfortably cover your mortgage and car payments, for example, before you even think about adding an investment loan to the mix.

Finally, you should have the stomach for leveraged investing. That means a high tolerance for risk and a long investment horizon. Leveraging is not a get-rich-quick scheme; most leveraged investors think in terms of 10, 15 or even 20 years.

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