Discuss Latest WCI Blog Post: How to Use Leverage and the Differences Between Good and Bad Debt

[The White Coat Investor]

There are good uses of leverage, and there are bad uses. Here's how you can use leverage to your best advantage as you invest.

The post How to Use Leverage and the Differences Between Good and Bad Debt appeared first on The White Coat Investor - Investing & Personal Finance for Doctors.



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[Bev]

Really?

[Nysoz]

Pretty good post regarding leverage. Basically everyone uses it at some point in their life and needs to understand what they're getting themselves into.

I'm biased and have a slight difference regarding using margin as leverage. More often than not, when people bring up margin loans to use as leverage, the example given is fully margining out the account in a highly risky investment to have it blow up in their face. Just like everything else in life there's a spectrum.

Like the post said, using leverage is a risk. Lower interest rate = lower risk, higher rate = higher risk. Now when you're investing on margin, you also get to choose how much risk you expose yourself to. If you can borrow with a margin loan at 1% and get a guaranteed 7.12% with an I bond, there's no extra risk there. The only risk you hold here is with the callable margin loan and if you borrow the right amount, you won't get a margin call except for a total market collapse (and there's bigger issues anyways).

One of the last points says that most readers of the forum don't need to use leverage. However, I almost guarantee that basically everyone has used leverage at one point in their life in the form of a mortgage or investing anything while still having student loans/said mortgage.

So if you use the right amount of margin to place yourself at essentially no risk of a margin call, invest responsibly, it's a good way to accelerate growth. The hard part is finding the balance between the two without getting burned. Ultimately like the post says, leverage/loans are just a tool to use. It's up to the individual to learn to use it responsibly or completely optional (for the most part) for high earners.

[TheDangerZone]

I enjoyed reading this guest piece. Nicely written.

[triad]

seemed pretty dismissive of margin loans. I was planning on funding lifestyle via margin loans for a year or two before paying it off by selling from my taxable account. this way I defer cap gains for a year at the cost of my 2% margin loan (interest deductible I believe). it would be possible to get a margin call but half of that account is in bonds and the portfolio would have to lose over 75% to get called, so realistically not much risk of that happening.

[Craigslist]

If you can borrow with a margin loan at 1% and get a guaranteed 7.12% with an I bond,

What, that sounds genius.

[Lordosis]

What, that sounds genius.

Except money is fungible. Taking a margin loan and putting it into ibonds is oversimplification. Everything you buy and do and invest in is on credit. Not just what you took the loan out for. It probably does not actually matter in the end but if you need a loan to buy ibonds then you also needed a loan to buy groceries this week.

Pretty much the same for anyone living with a mortgage or student loans. Again if done within reason it probably does not matter. And anyone hanging around financial forums probably is investing the rest but I would argue that debt is bad for the vast majority of people because it easily allows lifestyle inflation above current means with the hope it can be paid back later.

[Nysoz]

I mean some people want a certain amount of cash in their bank account laying around as an emergency fund. So instead of buying I bonds with your emergency fund cash that they have to replete to feel comfortable, just get more cash at the 1% margin loan rate to get the 7.14% I bond return.

It's all psychological of course. Margin or other loans don't have to be bad. The keys are to use them responsibly and to use them to fund more assets instead of using them to fund lifestyle increases. Very much a gray area and sometimes difficult to separate though.

[Lordosis]

I mean some people want a certain amount of cash in their bank account laying around as an emergency fund. So instead of buying I bonds with your emergency fund cash that they have to replete to feel comfortable, just get more cash at the 1% margin loan rate to get the 7.14% I bond return.

It's all psychological of course. Margin or other loans don't have to be bad. The keys are to use them responsibly and to use them to fund more assets instead of using them to fund lifestyle increases. Very much a gray area and sometimes difficult to separate though.

Your case is obviously a success story but I would hazard a guess that you are the exception rather than the rule.

Whenever I hear arguments about what makes sense on paper for long term gains I always think back to the market timer bogleheads thread. He was right that on paper his plan was sound. But timing is a b!tch and he could not cover his loses through the crash.

https://www.bogleheads.org/forum/viewtopic.php?t=5934

[Nysoz]

It's all about managing risk and using any type of debt responsibly. This person had a net worth of -$50k and over leveraged at the worst possible time to lose $210k. FAQ point 4 talks about having $20k and borrowing $100k to invest. Not healthy and responsible use of debt/margin. I haven't seen any examples of people using a responsible level of margin to invest in reasonable investments get wiped out but would appreciate examples if you've come across any.

The mortgage retirement opinion piece is wondering why you shouldn't apply real estate levels of leverage to stocks and this person is the example of why. Callable vs non-callable debt. Also leverage in real estate is ridiculous. $100k lets you buy a $1M house. $100k on margin lets you buy $150-200k of shares.

The levels of leverage/margin I'm talking about is if you have $1M you can use 10% of that for reasonable investments to cover the margin/interest rate. Use it to buy I bonds for no additional risk. Instruments like QYLD for a 12% dividend rate that covers the 1% margin rate is getting riskier but still should return more in the long run. Stable coins I think are riskier but still another option. Even if the market crashes 50%, you shouldn't get a margin call and the investments are still returning more than the interest accrued which allows time for things to recover.

$1M in 20 years with 7% returns, you end up with $3.87M.

An overly simplified example is if you use 10% of your portfolio for margin to buy QYLD and add an additional $1000 a month to compound at 7%, then you end up with $4.36M after the 20 years or get to $3.79M in 18 years. Yes there's risk (and a lot of moving parts and variables such as taxes) but overall relatively minimal. There would have to be a crash of around 80% to get a margin call.

Once again, completely unnecessary for any high earner to get to their goal. But used responsibly can potentially get you there faster or higher through compounding.

[bovie]

seemed pretty dismissive of margin loans. I was planning on funding lifestyle via margin loans for a year or two before paying it off by selling from my taxable account. this way I defer cap gains for a year at the cost of my 2% margin loan (interest deductible I believe). it would be possible to get a margin call but half of that account is in bonds and the portfolio would have to lose over 75% to get called, so realistically not much risk of that happening.

Why only a year or two? You lose all the benefit when you sell.

The whole point is to do it indefinitely until you croak, at which time your loan will then be paid off by your estate after the basis on your collateral (i.e., taxable account) is stepped up.

That’s my plan, for sure. Assuming even moderate historical equity returns, low single-digit percent interest sure beats LTCG rate.

[triad]

Why only a year or two? You lose all the benefit when you sell.

The whole point is to do it indefinitely until you croak, at which time your loan will then be paid off by your estate after the basis on your collateral (i.e., taxable account) is stepped up.

That’s my plan, for sure. Assuming even moderate historical equity returns, single-digit percent interest sure beats LTCG rate.

If i had a MUCH larger taxable account or a shorter expected lifespan (currently in my early 40s) I would plan to do that. but the margin rate is variable, at some point it will surpass inflation so that will end the free lunch. it still might happen if my taxable acct grows much faster than my margin balance.

[Tim]

Rather plays down the role of credit in both personal and professional finances. It seems to point out that "convenience" is the only reason and relates to credit cards. Credit is more than convenience, it is a huge efficiency. The old way was sending a check or a wire transfer or setting up and account with a full blown credit limit on each customer. Someone always wanted to "guarantee payment" prior to shipping and order or accepting payment. Cash or credit was a big deal. Only local checks accepted. People traveled with a huge wad of traveler's checks or cash. Instant pre-approved unsecured credit is a huge efficiency in one's life.
Everything from utility deposits, auto insurance and homeowner's insurance rates are impacted. Get your unsecured credit established and use it and increase the limits. Those credit cards are the core of the view of your financial stability. It is like insurance, a waste until you need it. You will need it to get a fair shake.

Unsecured debt capacity is really important. Just wise not to use it. The most expensive credit is it is carried as debt. A valuable tool but use it wisely.

[auggie1983]

If i had a MUCH larger taxable account or a shorter expected lifespan (currently in my early 40s) I would plan to do that. but the margin rate is variable, at some point it will surpass inflation so that will end the free lunch. it still might happen if my taxable acct grows much faster than my margin balance.

Maybe it will surpass inflation, but will it surpass LTCG? Doubtful

[xraygoggles]

If i had a MUCH larger taxable account or a shorter expected lifespan (currently in my early 40s) I would plan to do that. but the margin rate is variable, at some point it will surpass inflation so that will end the free lunch. it still might happen if my taxable acct grows much faster than my margin balance.

Not sure what you mean by 'MUCH larger' but I started my pledged asset line (PAL) at 400k or so, and I was offered sub-4% at that time. As it grows larger, your rate gets progressively smaller.

I like having a PAL mainly because I will be able to borrow large chunks if I need to in the future, without selling the shares (I only have indexes and bonds in there) and as long as I borrow only a reasonable amount from there, I will almost certainly never have to liquidate the shares or be margin called.

At the end of the day, it comes down to risk management. There is no right or wrong answer, personal finance is personal, etc.