Leverage - using other peoples money to get rich (or go broke...)

When people talk about the love affair Australians and those in other countries have with investment property, and using real estate to get rich, they are really talking about the use of massive amounts of debt. This is using other peoples money to leverage your money into a much larger amount. There is nothing wrong with it if it is done wisely, in moderation, and while understanding the risks associated with it. Let's look at the typical method of buying a house for a young person:

Lily has taken a few years off of buying Faberge eggs and has been saving money towards a house deposit. She now has $100,000 to use for the purchase. She has decided against buying a "forever home" and has instead found a house she'd be happy to live in but that also makes sense as a future investment property. It is close to public transport, in a nice neighbourhood, has a decent sized block of land but is low maintenance etc. It costs $1,000,000.

Lily uses the minimum of $50,000 of her savings as a 5% deposit on the house, with the remaining $50,000 spent on stamp duty and other government fees (around $35,000 for Queensland Australia in 2021 even for 1st home buyers...), building and pest inspections and some furniture to live in the house with. 

Lily now has control over a $1,000,000 asset for the measly sum of $100,000. She has leveraged her original money 9 times, adding an additional $900,000 of exposure to assets. 

Looking closer at these numbers what has happened? Essentially Lily has LOST half of her original money (assuming the furniture she buys does not have much value after it is bought, which is not exactly true but close enough for this example). Her $100,000 turned into $50,000 after the fees and costs. That is money that Lily cannot get back, and if she were to sell the place she would get hit with another big batch of selling fees (real estate agent fees, inspections, advertising etc.) that would likely wipe out a large portion of the $50,000 she had left after the original buying fees. In reality Lily has "lost" close to all the money she had saved to gain exposure to the $1,000,000 asset. 

Why would she do this?

This is a house that will one day turn into an investment property, so Lily assumes that long-term the house will rise in value. While Lily may have "lost" the original deposit money she has gained exposure to something that might accelerate her net worth. Forgetting maintenance costs for a minute - If the house goes up 10% in value she has regained all of her deposit money back. If it goes up 20% she has doubled her original investment. This is why we do it. To double her original $100,000 WITHOUT leverage would - on average - take around 7 years in shares with no leverage. It could be much quicker, but it could be much longer. House prices can often go up 20% in a year or two in Australia, so she might double her money in a much shorter time frame.

This is not without risk though, just ask anyone who invested in regional mining-related towns like Gladstone, Biloela, Emerald etc. in the early 2010's. A 10% drop in the house price after Lily bought it would reduce the value to $900,000, meaning that not only did she lose the $100,000 deposit but she now has a NEGATIVE net worth of -$100,000. that doesn't count the costs of maintenance, council fees etc. etc. that often make home ownership feel like financial death by a thousand cuts.

So if that sounds a bit scary - what about leveraging into shares? The traditional method is called getting a "margin loan". Now THAT is scary! Essentially you own some shares, then borrow against the value of those shares to buy more. Very similar to the home loan example above EXCEPT the buyer fee is negligible. For your $100,000 deposit you might pay <$10 now in fees to purchase another $100,000 in shares. This sounds WAY better! The catch however is in the definition of a margin loan, which means your assets are "in margin". The way these loans can offer extremely low rates, often less than home loans, is that they can IMMEDIATELY sell your shares if the proportion of the total value of the assets that is your money has dropped enough to go below a set threshold (often 50%) and you can't provide the money within a couple of days or even less to top it back up above the loan value. This is typically at a horrible time, for example during a financial meltdown where you've also just lost your job. Fancy losing all your investments savings AND your job at the same time? Not me. For an explanation of it go here, but in reality it is not worth reading as this is not something you should be touching unless you are very well versed in how shares and money work. I wouldn't touch a margin loan nor see any reason I'd ever recommend one to anyone. They are a great way to lose everything very quickly.  

Another, newer method of leveraging into shares is with products like the recent NAB Equity Builder. It is similar to a margin loan in that you buy shares and then get a loan from the bank to buy more of them, however it does not have a margin call. This means that if the share market goes down you don't have to top it up or sell any of your shares. The loan rates are a little higher than traditional home loans, and there are restrictions on what shares you can buy (mostly index funds which is good!), but in my opinion this is a great option for young people looking to leverage into shares without the catastrophic risks of a margin loan. But you have to ask yourself do you really want to leverage into shares when you have so little experience with them? Statistically it makes a lot of sense to do it, but psychologically shares are hard enough WITHOUT the leverage. What I do like about this though is that you need a reasonable amount of shares to be able to get a loan, so hopefully you have had some experience with the volatility of the share market to reach this point. My concern is that someone has saved money in the bank, then thought "I want to leverage into shares" so they buy some index funds and get the loan at the same time. This is NOT a good way to enter the market, as the volatility of shares is a shock at the best of times, let alone if you are leveraged into it. If you do however have some experience with the share market, and have had the chance to go through a serious shock (no, that is not a 5% decline in a month) where all the headlines say the sky is falling and you must sell everything without losing your nerve, this could be a great opportunity for you. Remember, the loan is in todays dolllars so both the investment return and inflation are working for (or potentially against) you. Over a 10 year time frame statistically the odds are likely in your favour, but that doesn't mean they will favour you.  

Wrapping up - leverage amplifies gains and losses. As of 2021 we are currently in the midst of a generational housing boom. These things happen from time to time and no one knows how or when it will end. FOMO is a huge factor now, so it is understandable that people feel like they must buy a house now, invest in shares, or speculate in dogecoin, or they never will be able to afford it and will miss "the boat". You can backtest pretty much any asset at the moment and say "if only last year I'd leveraged into XYZ I would have made 10 times what I invested and be rich now!". That is hindsight bias, the most accurate and useless type of vision. These assets have gone up that much in large part because of random, unforeseen events ties to one of the deadliest pandemics the world has ever seen. Noone knew what would happen in March 2020 when the world looked like it was on the brink of a depression. If you think shares tanked then, down around 30%, imagine if you had to sell an apartment in a major city within a day? Good luck getting half your money back on that.   

While we haven't seen this exact scenario, no one in any of our lifetimes has, history echoes. We've seen situations like this before, and heard every one of the stories about "my child will never be able to buy a house" or "if you don't own this shitcoin/stock/beanie baby/tulip/spice you will be poor forever" over the past decades/centuries whenever there is a runup in prices. Funnily enough, people can still buy houses, invest in shares and blow there money on rampant speculation. Maybe the house is not exactly where you want to live your "dream" life, but there are plenty of places where houses don't cost too much and you can live comfortably on a meagre income. Maybe you do miss a tripling in share prices, or 100x gain in some random crypto coin, but there will always be more opportunities. Just don't blow your finances up in the meantime.   

ADDED NOTE: If you are borrowing money to invest in something that provides an income (very important as some shares don't provide a dividend) then it is very likely that you can claim the interest as a tax deduction. If you are on a high salary in Australia, where we have a very high tax rate, this can end up being very beneficial. For example:

If you borrow $100,000 to invest in shares at an interest rate of 3.95% (the current NAB Equity Builder rate at December 2021), you would be paying $3,950 in interest. If you can claim this back on tax at the rate of 37% (which is if your salary is between $90,000 and $180,000) you will have a tax credit of $1,461.50. So essentially it is only costing you $2,488.50 per year in interest after tax to gain another $100,000 exposure to the share market. You do however have to pay tax on the dividends you receive, so you can try and balance this out to maximise your after-tax situation.   

See specific tax advice on this, this is just an example.