Once you have paid off your non-mortgage debt and maxed out your retirement savings accounts, you might start to explore different strategies to grow your wealth more quickly. One question that many homeowners have is if it makes sense to use the equity in their home as leverage to invest?
Using leverage to invest amplifies your return when the value of your investment rises. The inverse is also true. Leverage will amplify your losses when the value of your investment declines. Using the equity in your home as leverage is particularly risky because it introduces the possibility of losing your home.
This post reviews how leverage works using examples and will detail the benefits and risks associated with investing with leverage.
What is leverage?
Let's start with the basics. Leverage simply means borrowing money to invest. There are many forms of leverage but one of the most common is to borrow against the equity in your home to invest. If someone is "leveraging their house" to invest", that simply means they are taking out a loan to invest and using their home as collateral.
These loans take one of two forms:
1. Mortgages
2. Home Equity Lines of Credit (HELOC).
Most people are familiar with mortgages. It's a loan against your home which often has a fixed interest rate, pre-determined payments, and amortization schedule (when you are set to pay the mortgage off).
A HELOC is a line of credit that is secured against the value of your home. HELOCs typically have lower interest rates than personal loans or unsecured lines of credit.
An important difference between a mortgage and HELOC is when you need to start paying the loan.
When you take out a mortgage you need to start paying the loan back right away.
When you take out a HELOC you only need to start paying the loan back when you use the money. A HELOC is what is called a "revolving line of credit". It gives you the opportunity but not the obligation to borrow.
Using home equity to invest is a double-edged sword
Using home equity to invest is one of the most common forms of leveraged investing for two reasons:
It's easy to get approved for a loan against your home.
Borrowing against your home typically results in lower interest rates.
You might be wondering, why is it so much easier to borrow against your home? The answer is because the bank knows you are going to do everything in your power to pay the loan off.
How does the bank know this? Because if you don't pay them back, the bank can take your home and sell it off to recoup what you owe them. If that doesn't scare you, it should. Leveraging your house to invest is not something that should be considered lightly.
Let's review the potential benefits and risks of leveraged investing.
How leverage works
Let's say you wanted to invest $20,000 but you only had $10,000 in cash that you could invest. So, you decide to borrow an additional $10,000 against your home.
On day one your wealth has increased by exactly $0.
You had $10,000 in equity before borrowing.
You have $10,000 of equity after borrowing. $20,000 in assets minus $10,000 in debt.
Using leverage will magnify your investment gains and losses by the amount of leverage you use.
The benefits of leveraging your house to invest
Using leverage can amplify your returns. That is why people are drawn to the idea of using leverage. It can help them quickly increase their wealth.
Staying with our example of investing $10,000 of your own money and borrowing $10,000, what happens if your investments increase in value by 10%?
Your investments increased in value by $2,000.
You have $12,000 in equity ($22,000 invested and $10,000 in debt).
Your return on the cash you put up was 20%.
What if you had $10,000 in cash and borrowed $20,000 and your investments increased by 10%?
Your investments have increased by $3,000.
You have $13,000 in equity ($33,000 invested and $20,000 in debt).
Your return on the cash you put up was 30%.
Some people are drawn to using leverage to invest because it has the potential to help them quickly grow their wealth.
But leverage goes both ways...
The risks of leveraging your house to invest
The obvious risk of borrowing money to invest in the risk that your investments don't perform well.
If you borrowed $10,000 to invest and the market were to crash and your investments suddenly dropped by 50%, your equity would drop from $10,000 to $0.
You have $10,000 in assets.
You have $10,000 in debt.
You would be in a position of a 100% loss.
If you borrowed $20,000, your equity would drop from $10,000 to -$5,000. You would be in a position of a 150% loss.
That sounds stressful as hell!
Since you used your house to invest you need to ensure you pay back the debt or risk losing your home.
You are the greatest risk of all
For long term investors who are well diversified in something like a low-cost index fund and the market drops 50% you have really only experience a "paper loss". If you hold your investments for the long term, you will recover some or all of your losses as the market recovers.
However, the biggest risk of all is what is called "behavioral risk". Meaning your behavior is the risk.
If you invest $10,000 and the market drops by 50%, that hurts. If you borrow another $20,000 to invest and the market drops by 50% that can be terrifying.
Now think if you add an extra zero to these numbers. It could scare you to do something stupid, like sell when the market is at the bottom. Now you have turned a "paper loss" into a real loss. Plus you still owe money on the loan you used to invest.
Bottom line
Using leverage to invest simply acts as a multiplier on your returns. When the market is going up, those multipliers look great. When the market is dropping, it can be very scary. Whether it makes sense for you to use leverage to invest comes down to your particular circumstances and your appetite for risk.
Here's one thing I know for sure if you have never experienced a stock market crash you should stay away from using leverage. It's easy to say that you would not sell at the bottom, but if you have not lived through a crash you don't know how you will react.
That is why I am not using leverage to invest at this time. When the market crashed back in 2008, I was 19 and had no money invested in the market. I've only really known a historic bull market during my investing career. I'd like to think I would be calm and cool in a market crash, but I won't know for sure until I live through one.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions