“Leverage is the only way a smart guy can go broke.” – Warren Buffett.
Borrowing to invest. The idea is almost as old as investing itself. Australians know the concept only too well, having dramatically increased our household debt levels as we chase ever-higher property prices.
And, thus far at least, it’s been a successful strategy – using the bank’s money to lock in a price on an asset that has gone nowhere but up (quiet, you West Australians, we like our “property never goes down” fiction, thank you very much).
As it should be. After all, if you put $100,000 down and borrow the rest to buy a $1 million property, it needs to rise only 10 per cent, to $1.1 million, and you’ve doubled your money (the $100,000 profit compared with the $100,000 deposit you saved).
See, money for jam. Of course, if that same house fell in price to $900,000, your equity goes from $100,000 to, well, something you can carry around in a thimble ??? with space left for your finger.
Now, reasonable, intelligent people can disagree on will happen next with house prices, but the maths doesn’t lie. That is what leverage does – it magnifies your gains and losses – turning a 10 per cent change in an asset price into a huge win or a disastrous wipeout.
But this isn’t an article about property prices, or the wisdom of borrowing to buy a house. Instead, I want to look at its stepcousin: the margin loan.
That is the term given to an investment loan that is used to buy shares, because we used to say that using the bank’s money to buy shares was “buying on margin”. But it’s essentially the same thing: debt, used to buy an asset, secured against that asset.
But margin debt is different, in three important ways:
First, the interest rate is usually meaningfully higher than mortgage debt. That’s fair enough – the banks judge their risk to be higher, so charge borrowers more for the privilege. But it means you need to get a higher return to cover the cost of that debt.
Second, while a mortgage is secured against a house, and the bank could technically “call” its loan and force you to sell if you’re unable to refinance, it almost never happens. Banks don’t call housing loans. But they do call margin loans. All the time. If your equity falls, you need to top it up with new cash, or the bank can – and will – forcibly sell your shares.
Third, and more destructively, because share prices tend to be more volatile than house prices, short-term share price movements can destroy your portfolio, even if those same share prices recover. During the global financial crisis, share prices almost halved. If you had a margin loan that equated to, say, 70 per cent of your $1 million portfolio, a 50 per cent fall would have seen the bank sell all of your shares, at or near the bottom of the market, and you would have essentially nothing left. Back to square one. Compare that with someone who had a $300,000 portfolio and no debt – their portfolio is now higher than before the GFC. Foolish takeaway
That is the ugly side of leverage. Now, many of you reading this would hear my cautionary tale and think that you’ll be the exception to the rule. You would use margin sensibly. You wouldn’t get caught out. But, like the 90 per cent of drivers who believe themselves to be above average, you can’t all be right. Debt, used well, can be a great tool for wealth creation. But used badly, it can kill your retirement dream. And is that really worth the risk?
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Scott Phillips is the Motley Fool’s director of research. You can follow Scott on Twitter @TMFScottP. The Motley Fool’s purpose is to educate, amuse and enrich investors.