Tuesday, October 12, 2010

Using leverage safely

Any investor who is worth his/her salt will hate excessive debt, both on the balance sheets of the companies they have invested in, and on his/her personal balance sheet. But leverage used in moderation can help investors get higher returns. Some forms of leverage can, in fact, be considered a good thing. In this article, I will talk about 2 forms of leverage (deferred taxes and debt) that we can use in our personal, financial lives.

Deferred taxes

Invest as much as you can through a retirement account where you can avoid and/or defer taxes. By avoiding taxes through tax deductible contributions, you save money that will otherwise go to the government, and you will have more money to invest, this is probably the best form of leverage as you’re getting free money (not just the cost of the money, but the money itself) to invest.  Deferred taxes is also a great form of leverage, as by putting off paying taxes on your retirement account’s returns, your pre-tax returns get to compound without interruption. The interest on your deferred taxes: 0%.

Debt

Debt, even in small amounts, should be approached with extraordinary caution. The only time investors should consider borrowing money is when they can borrow long-term and the interest rate is low and fixed. Here are a few other things that investors should look at before deciding whether or not to take on debt:

Debt level

An investor should have a low debt level in relation to his/her investment portfolio. I personally think that investors shouldn’t have debt (taken on for investment purposes) totaling more than 10% of their investment portfolio (which excludes their house, emergency fund, and investments in retirement account).

Income

Your income should be able to very comfortably service the debt that you are planning to take on. If your income is not stable (maybe your pay is based a lot on commission), maybe taking out a loan is not the best option from you. But if you have diverse, stable sources of income, and your total income is high in relation to the loan repayments that you need to make if you were to take the loan, then you can consider taking on a little bit more debt (anything above 15% of my investment portfolio and I think I’ll start to get uncomfortable).

Keep some money in reserve

Keep aside some money that you can use to service your debt for a few months. This will buy you some time to get your finances in order in the event that you experience a drop in your income.

The type of loan

Some types of loans have lower interest than others, and some loans are tax deductible while others are not. Investors should find out which loan will require them to pay the lowest interest after taking into account tax deductions (if any) for their loan options, as the interest on the loan will, obviously, have a huge impact on the attractiveness of the loan.


If you have any questions, or have anything that you would like to add, please feel free to comment. Thank you for reading and may you always sustain good returns on your investment.