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Fuel for the FIRE - Leverage

By Victor, The Frugal Samuari

Chapter 19 of Aussie FIRE, a collaboration between 20 of Australia's top FIRE experts

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Introduction

Ah, debt and leverage. Those two words resonate with us all in different ways. Some people embrace and welcome them with open arms. Others cannot run away fast enough.

When applied correctly, leverage is the strategic tool that expands our resources beyond our capital limitations to produce greater results than we can generate by ourselves. The thing is though, many people misunderstand leverage. It’s risky. It’s a financial bondage. It destroys lives.

Yes, yes and all yes.

But.

What if you can harness it?

Accumulating wealth comes from the compound growth of personal and financial capital over time. The crucial aspect is that it doesn’t have to be your personal or financial capital.

I'll talk more about how you can use debt and leverage to help you reach FIRE. You'll have a much better understanding once you finish this chapter, especially on the topics:

The Basics of Debt and Leverage

Debt is simply money that you owe. Debt often occurs when a borrower seeks a loan from a lender. In most cases, the borrower will pay interest to the lender. This interest is the cost of the debt.

Leverage and debt often go hand in hand. Leverage is the use of debt to acquire something. And when leverage is used for investment purposes? That’s when the exciting stuff happens.

A simple example of how debt and leverage works is below:

Let’s say your friend Mike invests $1,000 of his own money and invests in stocks.

If the stocks go up 20%, then Mike is feeling pretty chuffed, as he has just made $200 from his original investment.

Your other friend Michaela sees what Mike has done… and decides to go for gold. She borrows $1,000 on top of her original $1,000 investment (so $2,000 in total).

If the stocks again go up 20%, she has made $400. She then pays back the $1,000 and keeps the $400 as a 40% return on her initial cash.

Conversely, if the stock prices drop 20% - Mike is down $200 or 20% of his money, but Michaela has taken a $400 or 40% haircut to hers (not factoring in any interest on the loan either).

Leverage = Debt when invested, multiplies return (both profits and losses).

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Pros and Cons of Financial Leverage

Before jumping into any investment idea, it is always good to understand both the pros and cons. This is even more so when we are discussing debt - or more specifically, investing with debt (leverage).

Pros:

  • You are able to obtain control over an investment for relatively smaller upfront investment.
  • You may be able to increase your purchasing power to acquire more assets through debt financing.
  • Usually, the interest and fees involved with leveraging is tax-deductible (check with your tax specialist).
  • If all goes well, financial leverage can lead to higher returns than if you had purchased it with just cash.

Cons:

  • If the investment falls in value, that fall is amplified!
  • Typically, there is an obligation to repay ongoing interest associated with the debt, this eats into cash-flow.
  • If you are over-leveraged, i.e. hold too much debt, things can go south very quickly if the market turns against you.
  • Each time you borrow money, you are putting your “credibility” at stake, this is reflected on your credit score.

There are numerous other benefits and risks involved with leverage, of course, factors such as interest rate changes (up and down), income changes (e.g. from rental increases or decreases from an investment property) or your own lifestyle changes (needing more/less money to service debt) – however the above are the main ones to consider when deciding whether debt and how much of it is right for you.

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Ways Debt and Leverage Can Be Used On Your FIRE Journey

So, you’re comfortable with the risks and understand the potential rewards with using leverage – but how exactly can we use debt to achieve our financial goals?

Well, the below are just some of the ways we can all utilize leverage. It’s important to remember that these are general strategies only – always seek professional advice to tailor a plan that suits you!

Strategy 1 - Gear up to build wealth!

Once you have a handle on managing your current debt levels, the time might come for you to consider borrowing for investment purposes.

By gearing (leveraging) up, you could potentially multiply your investment profits and achieve those wealth goals sooner.

To be successful in the long run, the investments you acquire with borrowed money must generate a total return (income and capital growth) that exceeds the after-tax costs of financing the investment.

Traditionally the two ways of leveraging are through property and shares.

Property (as investment loans)

  • You put a $100,000 deposit to buy a property worth $500,000.
  • The property value increases to $600,000.
  • The nominal return is a $100,000 gain or 20%, but the real return is 100% (less interest and fees)

Shares

  • The same principles work, but for a more detailed example:
  • A $5,000 investment, compounded at 10% over 20 years per annum = $33,637
  • A $10,000 investment, compounded at 10% over 20 years p.a. (with $5,000 borrowed funds at 7% capitalized over 20 years) will yield $67,275 less interest cost of $19,348 = $47,927.
  • Thereby resulting in a higher gain of $47,927 - $33,637 = $14,290

Strategy 2 - Effective use of a lump-sum (debt transformation)

If you were lucky enough to receive a financial windfall, such as a bonus from work or an inheritance, you may want to consider using the money to reduce your home loan and borrow an equivalent amount for investment purposes.

This is achieved through:

  • Utilizing the lump sum to reduce the home loan balance (either paying the lump sum directly into the loan or a 100% offset account) and;
  • Taking out an investment loan for an equivalent amount to be invested e.g. in property/shares.

This is known as debt transformation because it enables you to convert non-tax-deductible debt into a tax-deductible one (check with your tax specialist).

Although your overall debt level is unchanged, you could potentially reduce your after-tax interest cost considerably and establish an investment portfolio to help build your long-term wealth. Or alternatively, you can reduce your home loan balance faster using these tax savings.

Strategy 3 - Debt recycling

Following on from debt transformation, debt recycling is where you progressively redraw your home loan repayments for investment purposes, to replace non-tax-deductible debt with tax-deductible debt.

It allows us to build wealth for the long-term to meet our lifestyle goals whilst also having a home loan.

A typical way to do this is to borrow against the equity of your home as an investment loan.

However, it’s important to understand that you need to be able to cover the monthly expense of the new loan from your current cash-flow.

This is how it works:

  • Use the equity in your home to establish an investment loan
  • Invest the borrowed money in assets such as shares and/or property.
  • Use the income from the new investment, as well as any surplus cash-flow to reduce your outstanding loan balance.
  • At the end of each year, you borrow an amount equivalent to what you’ve paid off your home loan, to buy more investments.
  • Rinse and repeat until the home loan is repaid.

A word of caution.

Debt recycling is a higher-risk strategy because you’re using borrowed money to invest and using your own home equity to secure this debt.

If the investment performs poorly or interest rates rise, you are at risk of facing significant financial stress.

Before jumping in, it is important to consider the below:

  • It might take longer to pay off the original home loan, as surplus cash is re-directed to meet interest costs on the investment loan, which increases over time.
  • There is a material difference in cash-flow if any of the loans are either interest-only or principal and interest.
  • Interest rates between various lenders and loan products vary substantially, which has a direct impact on your cashflow.

Strategy 4 - Offset Your Investment Loans

If you have an investment loan and are currently saving for a future non-investment purpose e.g. a holiday or a new car, you might want to have a think of using the offset facility attached to your investment loan.

This is because if you had transferred all your monies to pay down the loan and then redraw the funds back out for a non-investment purpose – you have effectively diluted the tax deductibility of your investment loan, and hence reduced the portion of the interest which can be claimed as a tax deduction.

This is why depositing spare cash into a 100% offset account linked to the investment loan could be a better option, as you retain the tax deductibility of the loan and reduce your interest obligations at the same time.

As the offset account is separate to the loan, you can continue to make repayments or redraw funds without affecting the size of the investment loan and tax-deductibility of the interest.

By way of an example:

Our friend Michaela has an investment loan of $200,000 which she has used to purchase an investment property.

She has recently received a handy $20,000 bonus from work, which she plans to buy a new car in 12 months’ time.

She can either:

  • Pay $20,000 directly into the investment loan
    • In which case, the loan balance drops to $180,000, but when she redraws the $20,000 back out – she can only claim deductions on the $180,000 (as the $20,000 has diluted the original investment purpose of the loan); or she can,
  • Pay $20,000 directly into the investment loan offset account
    • This means she is effectively paying interest on $180,000.
    • When she redraws the funds out, she can still claim tax deductions against the original $200,000 – as the original loan is untouched.
  • A mortgage takes a long time to pay down.
  • Interest repayments tend to be higher as a proportion of income.
  • It is still an asset class, which means there is volatility (Google “negative equity and mining towns”).
  • Loan interest rates can rise.
  • Real estate transactions are illiquid, which means a higher likelihood of lower returns when selling if you need immediate cash-flow.

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Leverage Strategy Comparison Table

 

Gearing up!

Pros: Ability to multiply investment profits to accelerate wealth goals

Cons: As you are borrowing money to make money, the total return must exceed the cost of borrowing

Debt Transformation

Pros: Conversion of non-tax-deductible debt into a tax-deductible one.

Cons: Overall debt levels remain the same, only the tax treatment differs. Also reliant on investment portfolio increasing.

Debt Recycling

Pros: Similar to debt transformation but slower, allows conversion of non-tax-deductible debt into a tax-deductible one.

Cons: As you are borrowing against your own home, potentially putting your livelihood at risk if investments turn negative

Offsetting Investment Loan

Pros: Allows control over the tax treatment of your loan repayments should you decide to use it for personal use.

Cons: None that I can think of… unless you are tempted to use the money in offset at the casino, in which case it’s a big no-no!


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Common Asset Classes For Leverage

After reviewing these strategies, you’ve now decided you want to use more leverage to accelerate your FIRE journey, but what will you leverage into? Here are three of the most common asset classes and what to watch out for with them:

Real Estate

When you hear about large sums of debt, usually you think of real estate, as without debt buying into the property market would be extremely difficult to do.

Here are some of the benefits of using leverage in real estate:

  • Allows entry into the housing market.
  • You control how much you want to borrow, through your deposit level.
  • No margin calls if there is a housing market downturn.
  • Usually a lower loan interest rate than other asset classes.
  • More flexible features such as offset facilities, redraw options, loan holidays etc.

And some of the risks:

  • A mortgage takes a long time to pay down. 
  • Interest repayments tend to be higher as a proportion of income.
  • It is still an asset class, which means there is volatility (Google “negative equity and mining towns”). 
  • Loan interest rates can rise.
  • Real estate transactions are illiquid, which means a higher likelihood of lower returns when selling if you need immediate cash-flow.

Stocks

Just like real estate, you can leverage into the stock market through margin loans, either as a lump sum or regular instalments.

Here are some of the benefits of using leverage in the stock market:

  • You control how much you can borrow, as different stocks and managed funds have capped leverage levels e.g. 40% for the riskier stocks and up to 75% for the blue-chips.
  • Instalment gearing allows dollar-cost averaging (investments acquired at regular intervals to smooth out volatility).
  • Prepaying interest in advance (can also do with property), which allows greater cashflow certainty.

And some of the risks:

  • Usually a higher rate of interest than home loans.
  • Potential for margin calls if there is a market downturn (higher chance to lose much more than your initial investment).
  • Limited investment options, as it is subject to the lender.

As a short aside, but I worked for a margin lender many moons ago – smack bang in the middle of the GFC.

I saw things with my eyes which I cannot unsee and heard things with my ears which I cannot unhear.

Harrowing stuff.

Leveraged Share Fund or ETF

There are actively managed funds and passive ETFs which use leverage within their own investment for potential outperformance.

Here are some of the benefits of using leverage in managed funds/ETFs:

  • The fund is able to borrow at wholesale interest rates, which are generally lower than those available to individuals.
  • Usually, no margin calls are required if there is an investment market downturn.
  • Most of the loans are limited recourse, which means your personal liability is limited to the value of your initial investment.
  • Investing in the fund is much simpler than establishing a borrowing facility yourself.

And some of the risks:

  • Limited control over the gearing level.
  • Limited number of providers and investment options.
  • Interest on the fund borrowings is generally offset against fund income.
  • No tax deduction for interest is available to investors as it is fund who takes out the borrowing, not the investor.

There are many more asset classes which participate in leverage of course. Examples include the FX market - where leverage can and often go up to 500:1 ($1 controls $500); the futures market – where margin calls are part and parcel of the game (best evidenced in the Eddie Murphy movie Trading Places); the options market – where we enter the world of Iron Condors, Butterfly Spreads and Long Strangles; and much, much more.

But that’s entering the world of trading and speculation – not for the faint hearted. It’s a jungle out there.

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In Summary

Leverage in Real Estate

Pros:

Gain entry into the property market

More control over your investment

More flexibility in terms of loan features

Cons:

Loan amounts can be substantial compared to household income

An illiquid asset class which means longer transaction times, not good if you need cash urgently.

Interest rates will eventually rise

Leverage in Stocks

Pros:

You maintain control over borrowing amount

Allows dollar-cost averaging into investments

Can prepay loan interest in advance each year

Cons:

Potential for margin calls; you can lose more than your initial investment

Investment options are subject to the lender

Usually higher interest rates than home loans

Leverage in Share Funds or ETF

Pros:

Usually, personal liability limited to your initial investment (no margin calls)

Can buy into greater exposure of underlying assets

Leverage (see what I did there) into professional experience and management

Cons:

Lack of control over what fund is invested in

Lack of visibility over underlying assets

Can be illiquid (redemption freezes) if significant volatility exists

 

I must say I thoroughly enjoyed writing this chapter, as debt and leverage are concepts quite close to my heart.

MrsFrugalSamurai and I are pretty deep in the real estate FIRE journey ourselves.

We both use the notions detailed here on a daily basis, and I sincerely hope that you can take some of this away on your own path, be it in real estate, or shares, or whatever you choose – please remember, investing is all about managing risk, and risk is there to be controlled.

Happy Investing!

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About Victor from The Frugal Samurai | thefrugalsamurai.com

Hi, I’m Victor, a 30-something millennial from Sydney, Australia. Growing up, no one showed me how to attain wealth so I’ve had to teach myself the hard way. I share my journey to being financially independent at thefrugalsamurai.com – I typically focus on investing, personal finance and development as well as commenting on topical financial issues. I’ve worked in the financial industry for over 13 years (and counting) and this allows me a unique perspective as a fly on the wall.

 


 

At Pearler, we pride ourselves on the quality of the financial advice we give. Please note though, that this advice has not been tailored for you. You have unique financial goals, circumstances and needs which may make this advice inappropriate, and it is important that you know whether it applies to you. If you are unsure we urge you to speak to someone you trust who is competent with money and understands your individual needs, whether they be a trusted friend or professional.

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