Yes, it still makes sense to use leverage today.
Let me explain… 🙂
Leverage in a higher interest rate environment
My margin interest rate used to be just 1.8% last year.
Borrowing money at this low rate to buy stocks was a no brainer since the stock market returns on average way more than that.
However, today my margin rate has gone up to 4.5% due to all the rate hikes.
So this presents a dilemma. Should I continue using borrowed money to invest or should I prioritize on paying back my debt?
I believe the right thing to do in my situation is to continue using leverage.
That’s because although interest rates are higher, the expected returns of my investments are also higher. 😀
The cost of borrowing is higher than before, but…
While the cost of money has been increasing, stocks and bonds have been losing value.
I recently explained how a stock market correction impacts future expected returns.
A 25% decline in the S&P 500 like we’ve seen this year has historically produced a 22% return just 1 year later, and a 37% return after 3 years.
For context, the stock market returns only 8% to 10% on average across all years.
Conclusion? Even though interest rates have increased by a few percentage points, the increase of expected stock returns are magnitudes greater.
In fact, I borrowed $100,000 earlier this year to buy a bunch of new stocks due to cheap valuations. This action hasn’t paid off yet. But let’s see where stocks end up a year from now. My guess is much higher than now. 🙂
Each economic crisis is unique. With inflation being so high this time it doesn’t make sense to pay down debt for me.
The recent inflation data shows that Canada’s CPI is at 6.9%. It’s down from earlier this year but still above the cost of borrowing money.
As long as real interest rates remain negative and stock are trading at a long term discount, I see no reason to de-leverage. 🙂
My primary focus is growing my net worth. So if the investment I own returns 10+ percent and I can borrow at less than 5 percent, then borrowing is a more efficient choice than selling. 😀
Random Useless Fact:
Does using leverage still make sense with high interest rates?
I’m getting either 17% or 12% on most private mortgages so I still think it’s a good idea. However I’m more cautious and being more selective with deals. Also I’m trying to put that money towards goals, getting stuff done at home etc.
Those are amazing returns. You’re always busy with different projects going on, haha. 🤓
Just curious..Which brokerage do you use which gives you such a low margin rates
I’m using IBKR for my brokerage account.
You can see their current margin rates table here: https://www.interactivebrokers.com/en/trading/margin-rates.php
What if your rate was prime + 1 = 6.45% or higher? Would you still consider it?
I would still consider it but less inclined than right now.
For me to prioritize paying down debt interest rates would probably have to climb to 10% or higher.
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Has leveraged investing become any less advantageous since you retired and are presumably in a lower tax bracket?
The interest I’m able to write off is slightly lower. I haven’t noticed any changes to the way I do things yet, but will probably notice the difference when I do my taxes next year. 🙂
the only way an average “caveman” like myself can get ahead is by two magical things… compound interest and leverage lol I mean sure, there’s risk involved here and there but like the old timers say, fortune favors the brave
And luck favours those who take calculated risks. 🙂 A bear market is usually a good time to use leverage, as long as you don’t over do it.
I’m assuming you can deduct your margin interest from your potential profits?
I’ve been debating this a bit myself. I’ve got a variable portion of my mortgage (relatively small) that’s sitting in the low 5%. If you adjust investment returns for tax payable your risk-free return on paying that mortgage down is potentially toward 7.5% depending on your tax bracket. That’s pretty hard to turn down….
Yes, margin interest is tax deductible.
7.5% is no small return. In normal circumstances I would be inclined to take that over investing in the stock market.
One thing I like to take into consideration as well is the opportunity cost.
The average 1 year return of the S&P 500 after a 25% correction is +21.6%.
Given how the US stock market was down 25% earlier this year I think it’s harder to make the call of where to best allocate capital. 🙂