Quiz!
Which of the following statements are true?
- Borrowing to invest can make anyone wealthy.
- Borrowing to invest in a volatile fast growing investment, leads to higher long-term security at the price of lower short-term security.
- Borrowing to invest is never smart for young people.
- Borrowing to invest is never smart for retirees.
When Increased Leverage can Improve Your Short-Term Security
Borrowing to invest can let you enjoy excess returns equaling the investment growth minus the loan interest. While you commit to a fixed cost, to enjoy a volatile benefit, there is a case that can increase your overall short-term security, in addition to the typical higher long-term security. An example can demonstrate this point. Please read carefully the assumptions & notes below – most people are better off not borrowing to invest.
- Say you have $100k in investments (in Extended-Term Component), a $1M house with no mortgage, and you spend $100k per year. If you lost your job for more than about a year, you can be wiped with no cash to support yourself.
- Now, assume that you borrow $800k at 5% interest-only, and add to your investments. Even under tough investment scenarios, you can survive the 2 years out of a job.
The following table summarizes the impact of the borrowing-to-invest:
|
Impact of different leverage choices, with $100k in investments (in Extended-Term Component), $1M house, and a 2-year job loss, leading to $200k withdrawals |
||
| Case | No mortgage | $800k mortgage @ 5% |
| Good: Starting at 2003 | Out of cash after 1.5 years | +$1.74M after 2 years, owe $800k |
| Bad: Starting at 2008 | Out of cash after 0.8 years | +$410k after 2 years, owe $800k |
The leverage helped you avoid bankruptcy, by turning your illiquid house into a liquid source of cash. Surprisingly, whether your unemployment occurs during a stock surge, or the worst crash of your lifetime, it helps you survive an extended period of unemployment.
Important assumptions & notes:
- This article reviews only one aspect of leverage. The topic is complex and requires a thorough risk analysis.
- While the short-term security goes up in this case, and the long-term security would typically be higher, there could be a combination of an extreme decline combined with many years of withdrawals, that can negate the long-term benefits, resulting in an overall loss.
- The key to the increased short-term security is the improved spending/assets ratio. In the example above, there is a dramatic improvement from 100% ($100k/$100k) to 16% ($140k/$900k). If the interest on the loan is higher than your current spending rate, the loan will hurt your short-term security. This is typical of retirees. For example, if you have $4M and spend $120k/year, your spending rate is a comfortable 3%. Adding the loan, will increase your spending rate to 3.33% ($160k/$4.8M). While your long-term security can still benefit, it is not recommended for retirees, especially if the new withdrawal rate is high enough to lead to problems under severe declines.
- The loan cannot be called. This is typical of mortgages in the US, assuming you make all payments on time. This is not true for margin loans that may be called at the worst time – at the depth of a market decline.
- You invest the entire loan amount.
- Your spending habits stay the same, and you don’t get tempted to increase your spending with the extra $800k in the bank.
- You don’t sell in a panic after a decline like 2008, and don’t get a heart-attack. Either can turn the temporary decline into a permanent loss.
- As soon as you find another job, you go back to saving regularly. You never withhold investing at low points (after big declines).
- You may enjoy some of the short-term benefits above using a HELOC – a home equity line of credit, that is left not borrowed until the need comes up. There are some pitfalls to HELOCs to watch out for: (1) in rare cases it may be frozen to new borrowing, and (2) the interest rate is usually higher than mortgage rates. Also, without the actual borrowing to invest, you can’t get the long-term benefits.
- In the example above, you may be able to sell the house, but there are a number of issues with this plan: (1) When selling the house, you turn a temporary problem (job loss) into a longer-term issue – selling a house, moving, maybe later buying another house, and paying realtor fees; (2) You would not want to sell too soon, while hoping to find a job, but if you wait too long, you may need to sell in a rush, leading you to get underpaid for the house.
Quiz Answer:
Which of the following statements are true?
- Borrowing to invest can make anyone wealthy.
- Borrowing to invest in a volatile fast growing investment, leads to higher long-term security at the price of lower short-term security.
- Borrowing to invest is never smart for young people.
- Borrowing to invest is never smart for retirees.
None of the statements are true! Explanations:
- If you can qualify for large loans, you invest the full proceeds in a fast growing investment, you never panic and sell at a decline, you do a careful risk plan and a host of other conditions, you have a chance to become wealthy. If you mess up any of the conditions, you can go bankrupt, even if you started as a billionaire.
- See this month’s article – under certain conditions, you may enjoy higher short-term security along with a typical higher long-term security.
- Borrowing to invest may be smart for young people under the right conditions, and after a careful risk analysis.
- Borrowing to invest is typically not smart for retirees, but there may be unusual circumstances, where a retiree can maintain a very low withdrawal rate despite the borrowing, and also prefers the higher potential growth despite the higher volatility.