Borrowing to Invest: Margin, Rental Property and Business Loans

Borrowing to invest is how many businesses and property portfolios are built, and how many investors have been wiped out. The same mechanism does both. Leverage magnifies whatever happens to the asset, good or bad, and adds a cost that is due whether the investment works or not. This chapter explains how leverage changes returns, the main ways individuals borrow to invest (margin, rental property mortgages and business loans), the hurdle each investment has to clear, and the questions to answer before signing.

What leverage does to a result

Suppose half of an investment is your own money and half is borrowed. Every move in the asset's value lands entirely on your half, so it counts twice.

• If the asset rises 10%, your money rises about 20%, minus the interest on the loan.
• If the asset falls 10%, your money falls about 20%, plus the interest.
• If the asset falls 50%, your money is gone, and you still owe the loan.

Two things follow. First, borrowing helps only when the asset earns more than the loan costs, after tax. If a loan costs 7% and the investment earns 5%, every borrowed dollar loses money even in a year when nothing goes wrong. Second, the cost is certain and the return is not. Interest is due every month. The return arrives unevenly, and the bad years are exactly when lenders get nervous, values fall and income may also drop.

That is why the useful question is never "could this make money?" but "what happens to me in the bad case, and can I get through it without being forced to sell?"

Margin and other loans against investments

A margin loan lets you borrow from your broker against the stocks and funds in your account. Federal rules let you borrow up to 50% of the price of most stocks when you buy them, and FINRA rules require the equity in the account to stay at no less than 25% of its value; most brokers set a higher requirement of their own.

The arithmetic of a margin call is worth seeing once. Buy with half borrowed, and the loan is 50% of the starting value. If your equity must stay at least 25% of the account, the loan can be at most 75% of it, so a call comes when the account falls to two-thirds of its starting value: a drop of about 33%. With a 35% house requirement, the call comes after a drop of about 23%. Broad stock markets have fallen that far several times in living memory.

When a call comes, you must add cash or securities quickly, and the broker can sell your holdings without waiting for you and without asking which ones. Forced selling at the bottom is how temporary market falls become permanent losses. Margin rates are also variable and often well above mortgage rates.

Securities-based lines of credit work similarly for spending money rather than buying securities, with the same risk of forced sales. Leveraged ETFs, which aim for two or three times an index's daily move, build the leverage into the fund. Because they reset every day, their results over months can differ sharply from two or three times the index's return, especially in choppy markets. Their own prospectuses describe them as tools for short-term trading.

A rental property with a mortgage

Real estate is the most common form of leverage for individuals, because lenders will finance most of the price of a property for decades at a fixed rate. Suppose a property is bought with 20% down and a 30-year loan.

Borrowing $280,000 at 6.5% means a payment of $1,770 a month, every month, whether or not the unit is rented. The rent has to cover that plus property tax, insurance, repairs, periods with no tenant, and management if you hire it. Investment property loans also usually carry a somewhat higher rate than a loan on your own home.

The key comparison is the property's net yield, its rent minus operating costs as a share of its price, against the loan rate.

• Positive leverage: if the property nets more than the loan costs, borrowing raises your return on the cash you put in.
• Negative leverage: if the property nets less, borrowing lowers it. For example, a property netting 5% a year financed 80% at 6.5% loses money on the borrowed part. Before any rise in value, the return on your own cash works out to roughly minus 1% a year, and the investment depends entirely on appreciation to come out ahead.

Rental mortgage interest, property tax, repairs and depreciation are deducted against rental income on Schedule E, whether or not you itemize, but deductions reduce the cost of a loss rather than turning it into a gain. Lenders will also count the new payment in your debt-to-income ratio: Fannie Mae's guidelines generally cap total monthly debt payments at between 36% and 50% of gross income, depending on how the loan is underwritten. Most landlords who last hold cash reserves of several months of the property's full costs. The IRR calculator shows the return on a property's actual cash flows, including the down payment, yearly net rent and an assumed sale price.

Borrowing for a business

A business loan can fund equipment, inventory or expansion that earns more than it costs. The test is the same: the extra profit has to exceed the payment, reliably.

A term loan of $100,000 at 9.0% over five years costs $2,076 a month, $24,550 in total interest. Whatever the borrowed money funds needs to add at least that much to monthly profit after its own costs, starting soon, or the loan becomes a drain on the rest of the business.

A few features of business borrowing catch owners out:

• Personal guarantees. Most small-business lenders, including SBA lenders, require the owner to guarantee the loan personally, so a failed business can reach your home and savings.
• Matching the loan to its use. Short-term needs such as seasonal inventory suit a line of credit repaid as the stock sells. Long-lived equipment suits a term loan of similar length. Funding long-term projects with short-term credit creates a refinancing risk at the worst moment.
• Forecasts are not cash. Projected revenue is the least reliable number in any business plan. Test what happens if sales arrive later or smaller than planned.

Before you borrow to invest

Leverage belongs late in a financial plan, after the basics are secure. A short checklist:

1. Emergency fund in place, and no high-interest debt. Paying off a card at a high rate is a guaranteed return that almost no leveraged investment beats after risk.
2. The after-tax cost is clearly below the realistic return. Use a cautious estimate of the return, not the best year. Investment interest is deductible only up to your net investment income, and only if you itemize; business and rental interest follow their own rules.
3. You can survive the stress case. Rerun the numbers with the asset down 30%, the rate up two points, and your income down. If any of those forces a sale or a missed payment, the borrowing is too large.
4. The loan's terms cannot force you out at the bottom. Fixed rates, long terms and no margin calls are what make a mortgage survivable through a downturn. Variable rates and call provisions are what make margin dangerous.
5. You understand the asset. Borrowing to buy something you cannot value, or something designed for short-term trading, adds leverage to guesswork.