Leveraged Investing

by Kristina on October 25, 2010 · 1 comment

What would you say if I told you that you could invest in your retirement savings plan with someone else’s money?

I am sure that most of us would jump at the chance to gamble with someone else’s money but reap the reward if we win.  The investment strategy of using borrowed money to invest in either a retirement savings plan or an investment account is known as Leveraged Investing.

This is a somewhat popular investment strategy for individuals who want to buy investments within a deadline, if they do not have the available lump sum of cash to invest. Reasons for Leveraged Investing include but are not limited to investing in a retirement savings plan before the deadline, before the deadline to file personal income taxes, or if they are looking to buy a stock at a current price which could change within minutes.

A Leveraged Investment Loan is repaid on a weekly, biweekly, or monthly basis, just as a personal loan is repaid.

Leveraged investing is most commonly used to buy stocks and mutual funds. This is mostly because people hope to earn a higher rate of return on their investments than they are paying in interest on the loan.  Historically, Mutual Funds and Stocks offer a higher rate of return over the long term than Term Deposits.

Leveraged Investing is not generally a good investment strategy for fixed income investments such as Bonds, Guaranteed Investment Certificates, and Term Deposits. This is because fixed income investments are considered to be more secure than stocks and Mutual Funds; therefore they offer a lower rate of return on the investment.  It doesn’t make much financial sense to borrow money at an interest rate of 5% when we are only earning 2% on our investments.

However, as a Financial Planner I have seen many clients use this financial strategy against my better advice and buy term deposits with borrowed money.  Sometimes people use Leveraged Investing to make a last minute contribution into their retirement savings plan before the deadline. Then they intend to pay off the loan with their tax refund, therefore they will not accumulate any interest.

The good thing about using Leveraged Investing is that it allows us access to a lump sum of money (upon credit approval) to invest right away. The bad thing about using Leveraged Investing is that it is borrowed money.  Regardless of whether our investments gain or lose we are required to repay the loan. Therefore, if we invest via a loan when prices are falling we are still required to repay the loan while our investments are losing value.  In some cases I have even seen a client’s account whose investment value was actually lower than the remaining balance on their loan.  This is a less than ideal investment strategy.

Photo By GreggOconnell

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{ 1 comment… read it below or add one }

1 Writer's Coin October 25, 2010 at 7:40 am

You could also use options to leverage yourself without borrowing any money.

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