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February 04 newsletter

Increasing your investments with leverage

Like compounding growth, leverage is a useful concept both to understand and to apply to your investments, where appropriate.

Leverage means using some means, such as a loan, to create a different and stronger result from your investment (the result can be either good or bad).

A simple example:

You invest $100 for ten years. You are fortunate to achieve an investment return of 15% each year. Understanding the concept of compounding growth, you reinvest the investment earnings. At the end of the decade, your investment grows to $405. You have made a gain of $305, or a return of 305%, on your original investment of $100.

Now, let's assume that for the same investment you use $30 of your own money and borrow the remaining $70 at an interest rate of 8% pa. The same investment again increases to $405.

Out of the $405, you repay the $70 owed on your interest only loan. Over the 10 years, you pay $56 in interest. $70 * 8% = $5.60 interest each year. Ten years interest is $5.60 * 10 years = $56.

The real gain on your investment therefore is $249, which is $405 less $70 (the loan repayment) less $56 (the interest) and less $30 (your original investment). This is equivalent to a return of $830% on your original investment of $30.

If it is so easy to make money using leverage, why doesn't everyone do it? Well, many people do use leverage to increase their investments. It's one reason why investing in residential property has been so popular. Suddenly, the value of the property shoots up and you make a killing using the bank's money.

But, there is a catch. Like all investments, the bigger the potential of your return, the bigger the risk. The more you borrow, the higher the risk that you could default on the loan. For example, in residential property you could be put under huge cash flow pressure if interest rates were to increase suddenly, or the property was untenanted for a long period.

As part of your recommended portfolio , it may be appropriate to incorporate one of a number of investment options that use the concept of leverage.