BDC asked for an example for my post How Leverage Kills.
If you don’t understand debt then assume that the only time it might make sense to borrow is when your 30-year fixed-rate mortgage payment (including taxes & insurance) is less than your cost to rent. Assume that all other forms of debt will hold you back, prolong being a wage slave and reduce your retirement income.
The people that take issue with the generalizations above are probably trying to sell you something, and working on commission.
My family’s only borrowing is a 30-year fixed rate mortgage. Our mortgage payment is 60% of what it would cost us to rent. I made a calculated bet that our mortgage debt would provide a hedge against rental inflation.
Homeownership isn’t necessary for financial freedom. I bought the house because:
- I have a young family
- Don’t mind being geographically restricted
- Live in a great public school district
- My youngest won’t graduate high school until 2030
- Our city is likely to experience above average real economic growth
- I’m in a better part of town
Let’s assume our investor has $100,000 and owns an asset that yields 2% after expenses ($2,000 net income).
- Along comes her investment adviser and offers a portfolio loan – rates are low right now so the loan will cost her 3% per annum.
- Our investor decides to borrow $50,000 and purchase more of the same type of asset.
- Now she has $150,000 of assets, still yielding 2%, so $3,000 of income each year.
- The loan is interest only and costs her $1,500 per annum (3% of $50,000).
Where things get wonky is if the asset’s yield disappears — for example if a rental property is vacant — OR — if the capital value drops significantly — for example if a portfolio of stocks falls 50% in a bear market.
Let’s look at the 50% asset value decline.
- The value of the asset falls from $150,000 to $75,000.
- The value of the debt stays the same $50,000.
- Therefore the net equity value falls to $25,000.
- The net cash flows stay the same $3,000 from the asset, $1,500 interest to pay, $1,500 net after interest.
If you generate enough cash to pay your interest then you can ride out the bear market and wait for asset values to return to pre-crash highs.
However… a common feature of margin lending is the bank can ask for their money back… ….and they have a habit of asking at the worst time.
Sometimes, they don’t ask, under the terms of your loan they have rights to sell you out of your position.
Let’s have a look at what happens if the bank asks for their money back at the bottom of the market.
In that case, you crystallize a 75% equity loss ($100,000 to $25,000). You are left with $25,000, which will be worth $50,000 (earning $1,000 per annum) when the market recovers to pre-crash levels.
If you didn’t borrow, you earn your 2% per annum through the bear market and end up with $100,000 (earning $2,000 per annum) when the market recovers.
The chart shows major bull and bear markets.
Using your own money, a habit of margin finance could wipe your investment out every 10-25 years.
Some risks aren’t worth taking, especially with money that you can’t afford to lose.
So Why Borrow?
In a bull market, it’s tempting to borrow a much higher percentage of the total investment. Hedge funds, and investment banks, can get over 90% leveraged, against shareholders funds (also known as other people’s money).
When you guess right with other people’s money, the “house” will get rich quick. I worked in a business that received 20% of the profits generated.
When you guess wrong, the clients take the losses.
More on leverage in Part Four of my free eBook Live Long & Prosper – specifically pages 46 to 51.