Leveraged investing involves borrowing money to invest a larger amount up front, rather than if you made the contributions as income becomes available. While this does provide an opportunity to benefit from larger dividends and capital gains, leveraged investing presents some risks that you need to be aware of before funding investments with a loan or borrowing through a Home Equity Line of Credit (HELOC).
Perhaps the most obvious risk is that the value of the stocks you buy can drop while the amount owing on the loan stays the same. If the loan is backed up by the investments as collateral, the lender could ask that you immediately pay back part of the loan. With a HELOC or personal line of credit, you won’t have this issue and with a long term investment horizon, the stocks would likely recover.
The next issue is that you can magnify your losses. If you were able to pay for those stocks anyways then the loss is the same. However, if you purchased more shares since you had the available loan, then you multiplied the amount of your loss. This brings us to the next point…
By investing all at once, whether leveraged or not, you miss the benefits of Dollar cost averaging (DCA). Dollar cost averaging is when you invest an equal dollar amount on a periodic basis. This forces you to buy less shares when the price is high and more shares when the price is lower.
While there are quite a few investment risks, another risk is related to the loan. You might be comfortable with your interest payments since the current interest rates are historically low. But what if the rates increase, will you still be able to afford it? This is a real concern as there is room to potentially double or triple the current rate. If your payments are interest only, this means a doubling or tripling of your required payment.
So while leveraged investing has the potential to provide an increased gain, you have to understand and be comfortable with the additional risks involved.
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