Compound from day one.
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Have you ever wondered if borrowing money to trade or invest in stocks is a good idea? Well, this video could just answer that question.
When we look at building a stock trading system we need to incorporate and master many aspects, including psychology, risk management, technical and perhaps fundamental analysis, entry and exit criteria, through to the asset class and time horizon, amongst many others. But what is often forgotten is how to establish the initial equity balance to be able to apply the strategy, whilst the mere mention of borrowing the money is frowned upon. The video is not financial advice but is intended to at least explore an idea to create starting capital, or of course, increasing what you have further.
Many will be aware of the ability to borrow through the use of margin, however this video will focus on the more conventional way of borrowing capital like a bank loan or home equity. The approach will require an open mindset and will likely go against what most have been told through decades of conventional advice.
As always, If you find the content useful, why not consider exploring our library of stock market material, we cover everything from strategies to research studies, whilst I also disclose my personal strategy developed from over 30 years of experience, including our bespoke breakout scanner for identifying such trades. Ok, let’s get into the video…
To gauge our audience’s perception of borrowing to invest, I created a poll in the community. The question asked if they thought borrowing at an interest rate of 5% per year whilst investing the same amount at 3% per year was a bad idea.
Unsurprisingly 73% of viewers thought it would be a bad idea for numerous reasons, and although there is no clear cut right or wrong answer, I suspect that if everyone had the following information in front of them, the poll results would have been much closer.
The table shows a loan account with a starting balance of $10,000 with a fixed interest payment of 5%. We can see that throughout the 25 years the interest portion of the payment starts high, but reduces each year in alignment to the progressively decreasing loan balance, this is referred to amortization.
Let’s now put the $10,000 to work with a fixed interest rate investment of 3% per year over the same 25-year period. Unlike the loan interest which decreased each year, here we can see that the interest received each year increased, in alignment to the growing investment balance, this is referred to as compound interest.
With both sets of data we can now make a direct comparison. The $10,000 loan resulted in interest payments totalling just over $7,500, whereas the savings account accrued interest payments of just under $11,000. We can therefore calculate that the investment made a profit of $3400, despite earning 2% per annum less than the interest charged on the loan. This is the phenomena of compound interest and the benefits of starting the investment on day 1 with a lump sum. Of course there are other things to consider, like inflation and the cost of other opportunities, but in it’s simplest form the investment came out on top.
Let’s move on to a more realistic example by using a home equity loan as the source of funding. If we assume that the homeowners house is worth 300,000 and it currently has a mortgage of 100,000 against it, we could therefore assume that the owner would have the ability to increase the home loan to 200,000, thereby releasing 100,000.
The problem with refinancing a home is that many treat the equity released as a lottery win, funding a lifestyle with luxuries that are either short lived or depreciate in price quickly. Clearly the lavish lifestyle approach is a bad idea, leaving a debt burden to pay off for years to come.
Instead of being wasteful with the home equity loan, what would it look like if we invested the money into an investment with a great track record for long term growth? Let’s look at the S and P 500 as an example. Most will know that the index is made up of the largest 500 companies in the United States, making it a robust investment vehicle. In fact, since its introduction in 1957 the index has returned an average annualised return of 11.88%, becoming the benchmark for all hedge and pension funds to beat.
Let’s see how the numbers look when we compare the cost of the home equity loan, against the returns of investing the loan into the S and P index. In this example we assume the interest rate to be a fixed 5% per year to service the $100,000 home loan. This time we look at a more reasonable 15-year period.
Just like we saw in the previous example, the interest costs per year progressively decrease in alignment to the decreasing loan balance. The total of all interest paid during the 15-year period equated to just over $45,000.
Let’s now look at the performance of the investment. In this example we estimate a conservative 7% per year return from the index, considerably lower than the 11.8% long term average.
We can see that the interest received each year progressively increases in alignment to the growing investment, again the result of compound interest.
The total interest received over the 15-year period equated to just under $176,000, considerably more than the cost of paying the loan down. We used a conservative 7% return over a reasonable 15-year period and gained handsomely. What if we used the same metrics but over a typical 25-year mortgage? Well, the total interest payments would equate to just under $80,000, whereas the same $100,000’s invested at 7% would have grown into over $542,000, providing compounded interest to the sum of just over $442,000, a huge improvement on the cost of servicing the loan. In essence someone working hard to pay their mortgage down, instead of making use of their equity by ‘increasing’ the mortgage, would have lost out on a considerable fund at the end of the term. In fact, if we look at year 9 during the investment, you could have chosen to pay off the mortgage early, leaving over $100,000 in profit. The old cliché of getting your money working hard for you, and not you working hard for money, is certainly true here.
Borrowing money is of course a contentious subject and the mindset has always been to pay down your debt as soon as you can, decades of this engrained belief has led to most making it their lifetime goal, but as we have seen, it’s not always the best financial advice, especially if the interest payable is less than the interest achievable. Many of the largest companies in the world were built with huge debts, and these debts enabled them to leverage faster growth. Not all debt is bad, although it clearly depends on how you put it to use.
Using the example of a $300,000 home, let’s compare two homeowners and how their financial choices impact their eventual wealth.
First up we have David, a 40-year-old carpenter who saw the price of his property increase to a value of $300,000. He held a $100,000 home loan, costing him a fixed 5% interest per year, and planned to pay it off by the time he retired at 65.
Next we have Sarah, a 40 year old nurse, who like David saw her property increase in value to $300,000. Sarah however wanted some of her equity to work for her and took out an additional $100,000, she was also able to get a fixed 5% per year for the term of the total loan.
Let’s first look at the projected house price value for their properties. If we look at the last 30 years of US house price data, we find that prices have increased by 5.3% per year on average. Let’s use this figure to project 25 years ahead when David and Sarah retire. Both of their properties would likely be worth over a million dollars.
David’s total contribution including interest and principal, equated to just under $180,000, meaning that he would have the full 100% equity of his house value at the end of the 25-year term.
Sarah on the other hand, increased her home loan, but decided to only pay the interest on it, meaning that by the end of the 25-year term she would have made contributions totalling $250,000, but would still be left with the $200,000 home loan at the end of the term. Initially most would think that David had made the wisest decision, however it is the $100,000 additional borrowings that Sarah took that makes all the difference.
Using the very conservative 7% annual return invested in the S and P index, we can again see how the $100,000 additional home loan grew to over $540,000. If we now compare both individuals at retirement, looking at equity, liquidity, costs and income, we can then determine who has potentially made the better choice.
David paid his mortgage off and therefore had 100% equity totalling more than a million dollars, whereas Sarah decided not to pay any of the mortgage off, but due to capital appreciation she still has 81% equity totalling more than $880,000.
Due to David working hard to pay down his mortgage he did not have any significant cash available, anything he did have was tied up in the property or perhaps a pension. On the other hand, Sarah’s investment into the S and P 500 (Using funds borrowed from her home equity) grew to over $540,000.
David’s mortgage costs were zero, whereas Sarah still had an outstanding mortgage of $200,000 and needed to pay over $800 per month.
David’s income from any investments (other than a pension) would have been zero due to him deciding to pay down his mortgage, rather than using any available home equity to invest. Sarah on the other hand, had over $540,000 invested at an average 7% per year, potentially providing $38,000 per year or over $3,000 per month. She could of course decide to pay the remaining mortgage balance off and keep the balance invested, providing a near $2000 per month income.
Can you see how the conventional advice of staying out of debt and paying down your mortgage, is not always the best financial decision. If the debt can be fixed at a reasonable rate and you can invest into a proven investment over the long term, you may have more choices in the future. The key is to get your equity working for you, rather than being sat idle in the property, being unproductive.
Remember this is not financial advice, it will depend on your time horizon, finance terms available, and a whole host of other factors relating to your own personal situation, but the examples show that by thinking unconventionally, contrary to what most believe, using debt can leverage you into a better financial situation….
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