Borrowing to Invest: Understanding Leverage

This guide has been created by Transpacific Mergers & Acquisitions Commissionn to facilitate you in understanding how leveraging is utilized in investing. The guide is meant as a synopsis of investment borrowing. Before using borrowed money to capitalize on investments, you should know the potential risks involved for your portfolio if you use a leverage strategy.

Leverage Explained

The definition of ‘leveraged investing’ is borrowing capital to fund investments. You will be aware of leverage and its concept if you have:

• Borrowed capital to make supplementary contributions
• Utilized a line of credit for investments
• Purchased securities on margin trading from a broker-dealer

Leverage is used as a strategy for investing by individuals and companies alike; companies with substantial debt are considered substantially leveraged. A leverage strategy can be effective means of boosting returns on an investment portfolio, but it is wise to know the potential outcomes of borrowing capital to invest.

As well as increasing your gains, leverage also increases your losses too, so you should be in a position to withstand any losses if using borrowed money for investments. All leveraged investments must be suited to your goals and objectives for investment, and inline with the “knowing your client” details that you have given to your adviser or broker-dealer. The responsibility for ensuring you understand any investments and are content with the level of risk lies with you and your adviser.

Are You Able to Cope with the Risk?

Is leverage the right choice for you? Ask yourself this:

Do you identify the risks of borrowing capital to invest?

Are you in a position to lose the deposit you gave as a security against the loan?

Are your leveraged investments in line with the risk tolerance of your portfolio?

Are you comfortably able to pay your loan back?

What are the repayment and interest terms for your loan?

Are you keeping a watch on inflation/interest rates? Do you appreciate what their effects have on your return?

In a worst-case situation, how much would you lose? Do you have enough money to afford it?

Are you familiar with the tax penalties which relate to your investment(s)?

Example #1: Secured Investment Loan

John Doe secures his $50,000.00 credit line from the bank with his home as security so that he can buy stocks. This is an example of leverage as the funds John borrowed from the bank is being used to fund his stock investments. He is hoping that the investments will increase to the stage where he will earn more from them than he is paying on the credit line interest to the bank.

Even if he sees a drop in the value of his investments, he is still obligated to pay his line of credit each month at the rate he negotiated at the start. If he is unable to meet those monthly payments, he might be forced to sell those investments, even though they may have dropped in value. If the overall value of the investments does not cover the total owing, he might be pressed to sell his home.

Any form of an asset used as surety, even your house, may be taken by a creditor to discharge the debt.

Example #2: Mutual Fund Loan

Larry has accumulated $75,000.00 for when he retires in five years’ time. Feeling a little anxious that the money he has saved is not going to support his way of life, he seeks the advice of a salesperson of Mutual Funds. Larry is told that a lender with a loan can match his $75,000 investment, so he can use this to invest in additional mutual funds.

The salesperson has explained to Larry that he will have no difficulty in making the loan interest payments each month because each month, he can sell a small part of the mutual funds. We have presumed for this example that fund(s) companies permit ten percent of fund holdings to be sold per year without sales charge deferment being triggered.

The only way this strategy will work is if the new funds value gradually rises. If it decreases, Larry is still committed to monthly interest payments on the money he borrowed. Larry also needs to understand that the salesperson for the mutual fund will get his commission for the initial fund sale and could well also receive continuing trailer fees (commission). Another consideration for Larry might also be, does he want to get into debt over an investment where the value will fluctuate, given that he is nearing his retirement?

Remember, any investor taking out an investment loan should always be able to pay it back from cash flow. Give careful consideration to fees which are associated with this kind of investment. Numerous investors make use of leverage such as this to pay more money and produce a greater tax reimbursement. A typical approach is using a tax reimbursement to pay down or pay off the borrowing, thereby reducing the interest payable.

Advanced Leverage Practices

1. Margin Trading (Buying on Margin)

When buying securities or stocks on margin trading, you are paying for a percentage of the value of the stocks bought and borrowing the remainder from a recognized investment dealer. Federal Securities Laws state that an investment dealer is only allowed to loan you a specific percentage of the investment value, which is referred to as “maximum loan value” MLV. The MLV is determined by the kind of securities you are purchasing.

2. What Are the Hazards of Margin Borrowing?

If your loan value surpasses the loan valued allowed, a margin call is made by the broker-dealer, requesting you deposit further funds into your account to safeguard the loan. If you are not in a position to meet this margin call, your dealer will be able to offset the shortfall by selling some or perhaps all the investments you have, even if that means they are sold at a loss to you.

During periods of decline in the market, borrowing on margin could be one of quickest ways of losing money. Although it is possible to buy additional securities with margin than would be possible without any kind of loan, you may lose a lot more than the price you paid for the initial investment. You should be ready to credit further money at short notice so that you can achieve the margin requirements in a volatile market.

3. Short Selling Investments

Short or “short selling” is a leverage strategy which enables you to benefit from declining markets. If you believe the value of a stock or security is going to fall, your broker-dealer can lend shares of that stock/security which you can sell at the current higher value. If the price drops, you can buy them on the trade market at a lower value, then reimburse the borrowed security to the dealer-broker. You benefit from the yield of selling the stock at a higher value and buying them at the lower value.

4. What Risks are involved in Short Selling?

You are gambling on whether the stock/security price will drop, then again you may lose money if the price rises. Short selling margin obligations are far higher than conventional borrowing on margin due to the risks involved when using borrowed shares.

Be sure to know what your responsibilities and obligations are if margin borrowing, and make sure you can achieve them. If you are unable to meet the interest payments or any margin call for your account, the broker-dealer is legally entitled to sell your stocks/securities, even if this means you suffer a loss. It is best to avoid short selling if you don’t have the cash flow to cover any possible losses easily.