Stick one arm out in front of you and push down on your bicep with your other hand. Not much should happen. Now move your hand from your bicep down to your wrist, and push down again. It’s suddenly a lot harder to resist the downward pressure.

What happened? By moving your hand, you were able to amplify its power. In physics, this is known as leverage. In the world of investing, leverage is created when you borrow to invest.

Your Mortgage is a Perfect Example

If you make a $50,000 down payment on a property worth $500,000, you’re using just $50,000 to control something worth half a million dollars. You are amplifying the power of your money by a factor of 10.

Here’s some simplified math :

If your $500,000 property goes up in value by 10% to $550,000, you’ll have made $50,000. Based on your initial down payment of $50,000, that’s a 100% return. However, if your property goes down in value by 10% to $450,000, you’ll have lost your entire original investment.

Leverage magnifies the upside and the downside of your investment. Since the value of homes tends to rise over time, homeowners generally benefit from this phenomenon. Where things get interesting is when you borrow to invest in other things, such as stocks and bonds. If this is something you’re considering, here are some of the main issues to consider.

Where to Get the Money

If you have an account with a stock brokerage, they may offer you something called a margin account. This lets you use your investments as collateral to borrow additional money to invest. So if you buy $10,000 worth of Netflix shares, you may be able to borrow another $10,000 to invest, effectively doubling your upside potential.

However, if the value of your collateral falls, you will receive a margin call, which means you need to put up more money. If you can’t afford to do that, you may be forced to sell your shares at a loss, and end up in debt. Not pretty.

Borrowing against your home, either through a mortgage or a line of credit, is usually a safer place to get money to invest. The interest rate will generally be the lowest and if your investments take a dip you will not receive a margin call (although beware you can still end up owing more than your investments are worth if things don’t go well).

What to Invest In

Unless you have a real appetite for risk, you don’t want to borrow to invest in the types of investments that will either rocket to the moon or turn to dust. Most people will want to invest in something with a reasonably predictable long-term rate of return.

For example, if you can get a line of credit at 4% and invest in a solid portfolio of stocks and bonds that is expected to return 6% on average each year, you should come out ahead over time.

If your line of credit only requires you to pay the interest each month and not the principle, you may be able to invest in something that generates enough monthly income to cover your interest payments, such as dividend-paying stocks or a dividend ETF. In this scenario, it’s like having a super-charged investment portfolio for free.

Should You Actually Do This?

Borrowing to invest is a controversial subject, and for good reason. If everything goes right, you can generate a lot of extra wealth. In practice, many people make mistakes and get burned. Here are some minimum requirements :

• Think long term. Like real estate, stock markets generally rise over the long term, but can decline sharply in the short term. You need to give yourself enough time for long-term growth to materialize. That means having a time horizon of at least five years, and ideally longer.

• Invest prudently. Chasing hot stocks is a one-way ticket to trouble, especially if you’re using a margin account. You should approach borrowing to invest with a disciplined investment strategy that focuses on gradual, long-term growth. That typically means a diversified portfolio of quality investments.

• Budget your cash flow. If you’re going to borrow to invest, you need to know that you have enough cash flow to cover whatever interest and principal payments or margin calls may arise. A classic mistake is to run short on cash and be forced to realize a loss by selling your investments at the wrong time.

• Know your limit. If you take a long-term approach, invest in a disciplined manner and have the cash flow to cover any unexpected issues, it’s still wise to make sure you don’t overdo it. If things went badly, would it have a major impact on your lifestyle? Or mess up your retirement? If the answer is yes, scale things back.

Borrowing to invest taps into the power of leverage. This power can multiply your gains and your losses. It’s ultimately a personal decision based on your financial situation and comfort with risk. But if you’re smart about it, borrowing to invest may help you leapfrog towards your goals.

Should You Borrow from Your Home to Invest? by Planwell | zoocasa