Leverage
Kerry Back
Investing borrowed money is called leverage.
Your own money gains extra force.
The return, good or bad, on each $1 is amplified.
Example
Invest $100,000. Borrow $50,000. Buy $150,000 of stocks.
| Assets | Liabilities |
|---|---|
| Stocks 150,000 | Debt 50,000 |
| Equity |
|---|
| 100,000 |
- Leverage ratio = assets to equity.
- You are levered 1.5 to 1.
A Possible Ending to the Story
Suppose the stocks go up 10% and you’re charged 2% interest on the loan.
| Assets | Liabilities |
|---|---|
| Stocks 165,000 | Debt 51,000 |
| Equity |
|---|
| 114,000 |
- You made 10% plus one half of (10% minus 2%) \(= 0.10 + 0.5(0.10-0.02) = 0.14\)
- “one-half” because you borrowed 50%.
Conclusion
You make the stock return plus the fraction borrowed times (stock return minus borrowing rate).
Another possible ending
- Suppose the stocks fell by 10%.
- You lose 10% plus one half of (\(-\) 10% \(-\) 2% ).
- So, your loss is 16% on your $100,000 investment.
| Assets | Liabilities |
|---|---|
| Stocks 135,000 | Debt 51,000 |
| Equity |
|---|
| 84,000 |
The good and the bad
- You always make the stock return plus the fraction borrowed times (stock return minus borrowing rate).
- With 50% leverage and a 2% interest charge,
\[+10\text{%} \rightarrow +14\text{%}\]
\[-10\text{%} \rightarrow -16\text{%}\]
Margin loan rates
- It pays to shop around.
- Interactive Brokers charges
- the Fed Funds rate plus 1.5% on the first $100,000,
- and falling further after that.
- Oct 1, 2022:
- Fed Funds rate = 3.08%
- Prime rate = 6.25%