Financial Leverage

Financial Leverage
What is financial leverage? Financial leverage refers to investing in a specific asset believed to result in profit making in the future. This usually involves purchasing a property as investment.

However, financial leverage is a double-edged sword. It could multiply your gain, but it could also multiply your losses.

Application
Let us analyse the power of leverage as below:

For example, two people are investing in a property. John is buying a property worth $500,000 with 20% cash outlay while Paul is paying with 100% cash outlay. Assuming that the asset price will increase by 20%, what will be the return of capital for each of them?

  John
(Leverage)
Paul
(Non-leverage)
Price

$500,000.00

$500,000.00

Cash outlay/capital amount

$100,000.00

$500,000.00

Loan amount

$400,000.00

$0.00

In this scenario, John has a leverage of 80% as he borrowed $400,000 while Paul has zero leverage because he did not take up any loan.

Assume asset price increase by 20%

  John
(Leverage)
Paul
(Non-leverage)
Price (20% increase in price)

$600,000.00

$600,000.00

Less: Loan amount

$400,000.00

$0.00

Less: Cash outlay/capital amount

$100,000.00

$500,000.00

Profit

$100,000.00

$100,000.00

Profit over capital amount

100%

20%

Assuming the price of the asset increased by 20%, the returns for John is 100% ($100,000 / $100,000 x 100%) while Paul’s return is 20% ($100,000/$500,000). Well, John made a larger profit by leveraging in this case. What if the price goes the other way?

Assume asset price decrease by 20%

  John
(Leverage)
Paul
(Non-leverage)
Price (20% decrease in price)

$400,000.00

$400,000.00

Less: Loan amount

$400,000.00

$500,000.00

Less: Cash outlay/capital amount

$100,000.00

$0.00

Profit

-$100,000.00

-$100,000.00

Profit over capital amount

-100%

-20%

If the asset price decrease by 20%, John’s return of capital will be -100% while Paul’s will be -20%. In this scenario, John may be required by the bank to inject more capital to maintain the bank’s loan to value ratio. Loan to value ratio refers to the amount to maintain the allowable loan ratio stated in the original loan contract.

Loan to value ratio

  Asset price dropped by 20%
Asset value

$400,000.00

Allowable Loan amount
(80% of asset value)*

$320,000.00

Outstanding Loan**

$370,000.00

Top-up amount

-$50,000.00

*varies for different banks.
** assumed that John had been paying instalments for the original loan amount

Assuming asset price drop by 20% to $400,000 and the allowable loan amount is 80% of the asset value, which is $320,000; John’s outstanding loan amount is $370,000 (assuming he had been paying off his loan in monthly instalments), he will need to top up the difference of $50,000 to bank.

If John  could not top-up the $50,000, he will be defaulting the loan  eventually leading to foreclosure of property.

From the above example, we can observe that leveraging can multiply your return as well as your losses.  Financial leveraging is a useful tactic to increase wealth, however you need to be aware of the risks involved.

Some basic rules to use leverage
Before you consider using leverage as a strategy, go through the following two points as a guide.

  1.  Try doing a stress test scenario
    The example above illustrates a 20% reduction in asset value. You may want to assume a larger drop in asset price to be on the conservative side. So ask yourself, if the value drops by 30%, would you be able to top-up the required amount to maintain your loan and lower your risk of foreclosure?
  2. Contingency plan (??)
    Now using the example above; there is a 20% decrease in asset value. You will need to top up $50,000 to top up the bank loan. How would you fund this? You would need a contingency plan to address this scenario. What type of plan can you put in place? Some examples include, setting aside an emergency fund, or cash out your investments in other areas. Talk to your financial advisor for more options.

Financial instruments for leverage
Besides leverage for property, using the same concept, you can borrow from bank to invest in stocks, bonds and funds. Alternatively, you can invest in financial instruments that are leverages itself, for example Contract for difference (CFD), options and Forex. Talk to your financial advisor for more information.

To sum up, as mentioned before, financial leverage is a double-edged sword. Be sure you are able to take some risks and have sufficient emergency funds set aside, before using this as a tool in your portfolio.

Feel free to approach your financial advisor for more advice. You can contact me if you wish to too.