Dangers of leveraging or simply, don’t invest with borrowed money

IN FINANCE, the term leveraging means using borrowed money to create greater returns. 

“Leveraging” surely sounds more expensive than “borrowed money”, but it can mean your bankruptcy if you don’t watch out.

Some smarty-pants financial advisors may advise you to increase your investment returns by taking on debt, but I’m here to warn you against it.

Here’s why. Let’s say you have RM10,000 of savings that you can afford to lose and which you want to invest in the stock market. You think you have a smart investment strategy and will make 10% returns over a year. If you’re right, you are RM1,000 richer, congrats!

Now here’s how leveraging works. 

In addition to your RM10,000 of savings, you borrow RM30,000 at 5% interest per year, bringing your total investments to RM40,000. 

This RM40,000 will yield RM4,000 if you achieve the same 10% return. However, you will have to pay 5% interest on RM30,000, which is RM1,500. 

This means you are left with a net return of RM2,500 (RM4,000 minus RM1,500). This means the return on your savings has increased to RM2,500/RM10,000 = 25%, awesome!

You were able to increase the return on your savings because your average return of 10% is higher than the 5% interest you had to pay on your debt. 

But watch out when your investment strategy turns sour and instead of the value of your investment increasing by 10%, the value of your investments drops by a tiny 5%. 

This can always happen, because stock markets are unpredictable.

In the first example, your loss would have been 5% of RM10,000, which is RM500, a relatively small loss.

In the second example, your loss will be 5% of RM 40,000, which is RM2,000. 

But don’t forget about the interest of 5% that you need to repay on the RM30,000 loan, which is RM1,500. Now your total loss is suddenly seven times higher at RM3,500 (RM 2,000 + RM 1,500), or 35% of your savings, instead of 5%.

Just imagine if the value of your investments dropped by more than 5%, not only could your entire savings be wiped out, you could even end up in serious debt.

This is because you are also responsible for the loss of the money you borrowed. 

The bank doesn’t care if you make or lose money with the amount it has loaned you: it simply wants its interest paid and full repayment of the loan amount. 

Why? Because the bank’s reward is fixed at 5%: it doesn’t receive more if your investment goes well, but it also doesn’t receive less if your investment goes sour. This is the exact mechanism, which allows you to make much more or much less money.

The higher the interest you have to pay on your loan, the smaller the benefit leveraging will bring and the higher the risk that leveraging will work against you.

 Remember: if the returns increase so does the risk! You can be unlucky and have high risks with low returns, but you cannot be lucky and have high returns with low risks.
Leveraging is also popular in the corporate world. 

The big difference though is that if a leveraged company goes bankrupt, its stockholders won’t lose more than the value of their shares. 

If you would try to do the same, you could face personal bankruptcy! As you don’t have a limited liability company to protect you, you are much more vulnerable to the disadvantages of leveraging than companies are.

The one exception for individuals where leveraging is much more accepted – although that doesn’t mean it is risk-free – is with real estate, most notably the one house you call “home”. 

Virtually everybody buys a house with a small down-payment and a huge mortgage, which essentially is leveraging.

I’m not saying that real estate is a great, risk-free investment. It isn’t, take it from the guy who lost over RM100,000 on his own housing adventure. 

The reason it may be permissible is that, even if the market goes south, you still have a house to live in and you need somewhere to live in anyway. 

You can’t live in stocks that you bought with borrowed money. Please don’t invest with borrowed money.

Mark Reijman is co-founder and managing director of https://www.comparehero.my/ dedicated to increasing financial literacy and to help you save time and money by comparing all credit cards, personal loans and broadband plans in Malaysia.