Leverage - Amplifying Investment Returns
What is leverage?
Leverage is using borrowed funds to finance the acquisition of an investment to amplify the return on the investment.
Leverage in Stock Investment
One common example of leverage is using a margin account to borrow money secured by stocks you already own or acquire. Brokers will typically lend up to 50% of the value of a stock to buy other stocks.
Your equity position in stocks in a margin account is referred to as the margin. Margin is used to acquire more stocks than you could otherwise acquire if you were paying cash for those stocks.
If the value of the stock you purchase using margin goes up, your return on that investment is amplified by using margin in the acquisition.
You pay interest on the amount borrowed to buy stock. The interest rate varies from broker to broker and varies over time with the movement of interest rates. As an example, Charles Schwab, at the time of publication of this article was charging 12.125% per annum on loan balances of $50,000 to $99,999.99.
Chart 1 shows the comparison of return on investment purchasing stock with cash versus margin purchase. Column A shows a purchase of $100,000 of stock paying cash. Column B shows purchasing $100,000 of stock on margin (same amount of stock as Column A) utilizing $50,000 cash and a $50,000 margin loan. Column C shows purchasing $200,000 of stock using $100,000 cash (same cash investment at Column A) and margin loan of $100,000.
By using leverage the $50,000 investment using the margin account netted a rate of return of 17.88% versus the 15% return with the cash purchase.
Although the margin purchase amplifies the gains this is only true when the gain on the stock sale exceeds the amount of interest paid on the margin loan. If the stock had sold for less than 12.125% more than the price at which it was purchased the margin purchase transaction would a reduced gain on sale of the stock compared to cash transaction. And any loss on sale of the stock is greatly amplified.
Further, if a stock in the margin account moves significantly lower the margin loan can be called forcing the sale of the stock at the worst possible time. Simply, stated use of margin to purchase stock significantly increases the risk of investing in stocks but can increase the net return when the purchased stocks appreciate significantly.
Leverage in Real Estate Investment
Because real estate is a significantly less volatile investment than stocks it can be leveraged at a much higher percentage of value than 50%. On standard Fannie Mae and Freddie Mac investment purchases of single family residences an investor can borrower up to 85% of the purchase price.
The following example illustrates how leverage can impact the overall return on an investment. Our example looks at the return on residential real estate investment over a period of 10 years, assuming a 4% annual appreciation rate and a 7% per annum rate on the mortgage loan.
For simplicity, our example assumes the interest is paid annually with no reduction in principal. For a more detailed analysis of a residential real estate investment read our Comparison of Stocks vs Residential Real Estate Investment.
Column A shows a cash purchase of real estate for $200,000. Column B shows purchasing the same property with a 20% down payment ($40,000) and a loan of $160,000. Column C shows investing $200,000 cash to purchase real estate valued at $1 million (same amount of cash invested in Column A) with the same leverage ratios as Column B (20% down, 80% loan at 7% per annum).
The example illustrates how the leveraged transaction greatly amplifies the return on the investment. In this 10-year investment of $200,000 the leveraged transaction resulted in a return that was just short 2 ½ times the return on the cash transaction.
For a more detailed and accurate look at a residential real estate investment that includes a year by year breakdown of estimated expenses with a detailed 10-year analysis using a 30-year fixed-rate mortgage and taking into account the net gain after payment of income and capital gains tax check out our Stocks Investment vs Real Estate Investment Comparison.
We note that the attendant risks of leverage in a real estate transaction which are present in the margin account purchase of stocks do not exist with leveraged real estate. The lower interest rate on the leveraged portion of the transaction (7% on the real estate loan versus 12.125% stock margin loan) and the stability of real estate appreciation in value and rents make leverage of real estate have little or no bearing on the risk in the transaction assuming a cash-flow positive property is the subject of the transaction.
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