June 20, 2007, 3:22 am

You Might Not Be Aware of This: You Are Leveraging

by: The Financial Blogger    Category: Leveraging Strategies
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I’ve been reading several interesting posts about leveraging strategies recently. Four Pillars wrote an excellent series about his investment plan. He discussed the good and bad points about his strategy and I think he designed a plan that will create wealth over the long run. Then, there are two other posts regarding the risk related to leverage strategy. Thickenmywallet started with “Leveraging to Increase Investment Returns – walk before you run” and then, Canadian Capitalist with “Should you Leverage?”. All those posts made me think about my strategy and brought me to the following question: What is Leverage?

 

Between work, my family and this blog, I still find time to read. I’m presently reading Why We Want You to Be Rich written by Donald Trump and Robert T. Kiosaki. I am aware that they might not hold the keys to financial paradise and their thinking might sound weird sometimes, but we all have to admit that they definitely know something about money. This is where I find the most appropriate definition of leverage. Leverage is the action to do more with less. In their book, they are explaining that leverage started with the discovery of fire. The main difference between human beings and animals is leveraging.

 

What is the point with finance? It is that most people think that leverage is risky, probably too risky for them. This is why they would not consider contracting an investment loan or doing a Smith Manoeuvre. What they don’t know, is that they are already leveraging on other part of their life.

 

The easiest example to demonstrate is your property. By contracting a mortgage, you apply the definition of leverage. You are buying a bigger property with less money. Therefore, risks related to leverage strategies apply to your mortgage. Interest risk is fundamental. If you locked your mortgage five years ago for 4,25%, you might not be happy when you open your newspaper and look at the present mortgage rate. It goes to 7% for five years. One thing is sure; your mortgage payment will increase. Your property is not a liquid asset. Therefore, if you have to sell your property for any reasons, you might incur a loss in order to get a quick sale. There is also a risk that the property you just bought needs major renovations or that it is not increasing in value according to your plans.

 

On the other side, you also benefit from leverage. The mortgage grants you with the opportunity to buy a bigger property than your 10%-15% original cash down would allow you. Imagine what you would be getting for 40K? You would have to live in a fully equipped Grand Caravan for that price! Your property can also increase in value and you can make a good capital gain (that is not taxable!) at the sale. If you live in the USA, your mortgage is also tax deductible. Correct me if I’m wrong, but mortgages seem very close to other leverage tools.

 

The final point is: realize the impact of your actions. You might be leveraging at work using your talents to look good in front of your supervisor or you can be borrowing to purchase a car or some other goods. All debts are a form of leveraging. The real question is therefore: Do you know what to leverage on? And not: Should you leverage?

 

Everybody is leveraging. Leverage is for everybody. However, you must know what your interests are and leverage on those. Don’t expect to be successful in all kind of leveraging. Nonetheless, you should consider stopping leverage on bad debts and get going on the creation of asset.

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Comments

My post of leverage is strictly in the context of borrowing to invest in equities. Leveraging to buy a personal residence is NOT the same as leveraging to invest in the equity markets. For one thing, a home provides shelter and if you don’t own you have to rent anyway. Bottom line, you have to spend money on shelter. Carrying an investment loan isn’t one of life’s basic necessities.

Thanks for the link FB.

You’re right – we all leverage at one point or another but as CC pointed out, some leveraging is non-essential.

Mike

Thanks for the mention. Everyone does leverage but my post explicitly excludes leveraging for real estate and, like CC’s post, speaks only on leveraging for investment purposes.

by: The Financial Blogger | June 20th, 2007 (8:55 am)

CC, FB, TMW: I know that you were only talking about borrowing to invest. However, I think that people should realize that they are already leveraging in their life and therefore, it may not be that bad.

Having a home is not necessary. Although I would not live in an apartment again, it does fulfilled the need for a shelter with much less risk than contracting a mortgage.

I think that leverage is for everybody, maybe not using leverage to go on the stock market, but more on what people like/know better. Anyway, I’ll write more about that as I find this topic very inspiring.
Cheers,
FB.

Yup, a mortgage is leveraging. If one pays $10k down on a $200k house and borrows the $190k and the value of the house goes up $10k then there is a profit of 100% (minus the borrowing costs). As people in the USA are now discovering, houses as assets can also go down in price so you can lose 100% too, at least on paper and maybe in reality, if you are forced to sell.

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