Leverage or gearing as it is sometimes known is a useful servant but a cruel master. This week I look at some of the benefits and pitfalls of this investment technique.
Leverage is the use of borrowed money to magnify the returns on an investment. For example you have AED50,000 to invest but your bank will lend you another AED50,000 to invest in the same investment, using the whole investment as security. Many people will be familiar with leveraging in the form of property investment. Here typically the investor provides about 25% of the purchase price and borrows the balance.
So what are the features of leverage? Investors use leverage when they believe the return on the investment will be greater than the interest / profit plus fees being charged by the lender. When this occurs the returns can be significantly enhanced. However, if the investment falls in value the losses are magnified as well. This can result in a ‘Margin Call.’
A margin call is a demand from the bank for additional security as the value of the investment has fallen below a preset value. Typically the security will be additional cash. Whilst this hardly ever happens with property investment, it often occurs with other forms of leverage investment.
There are a number of key points to remember with leverage investment. Firstly, make sure you have cash on hand to cover any potential margin call. Secondly, recognise that leverage significantly increases the risk of an investment. Finally remember that whilst investment returns are unknown the cost of borrowing is certain and likely to rise in the next few years.
I hope the above was useful, please let me know if you have any questions or comments.