Debt is simply a way to maximize your Return that also enhances your Risk. Instead of only using $1,000 of your own money, you can use $1,000 of your own plus borrowing another $1,000 to invest. So if your money doubles, then $1,000 would become $2,000 or $1,000 can become $4,000 (with a $1,000 loan). But let’s not forget that if the market goes down, you’re always going to owe that $1,000 to someone, so it is more risky!
You can use debt to purchase investment properties and even to invest into companies or shares. Both are capital appreciating in nature and both generate an income. The best way to use debt to grow a portfolio is to ensure you’re benefiting from capital gains in the long-term as much as possible. By having too much debt, your outflows (interest repayments and other capital costs) might become more than your inflows (rent or dividends).This will force you to keep digging into your pocket to upkeep the investment, not necessarily something we love doing is bleeding cash and this is generally what forces a lot of people to sell their investments at a loss… Because they can’t afford to keep putting more and more money into their investment! By calculating the perfect debt to equity ratio, you can easily have more cash control. This might be a little harder with an investment property because of the high capital cost, but with a share portfolio, your margin loan can be adjusted a lot easier to put you in the perfect position to use debt to its maximum advantage.
So, you’re using debt to get the most out of your investing and return… But how about when it’s time to sell or reduce your risk position? Hopefully you’ll be selling or reducing your exposure at a gain, however a gain is normally accompanied by capital gains tax which can erode your net return. So when you think about using debt to invest, some other very important questions come into it:
> Do I expect to sell the investment at a gain?
> Do I one day want to payoff all debt in relation to my investments?
> WHEN do I think these occasions will occur?
> What is the most tax-effective way to hold the investment to ensure I pay the minimal amount of tax when either selling or reducing my debt exposure (perhaps when approaching retirement)?
Debt can be fantastic for an investment portfolio but it also poses many risks. Be sure to do a proper analysis of any investment (including the life-cycle of the investment) before going into it and don’t just do it for the tax benefits.
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