Margin & LeveragePersonal Finance
If an item bought with debt increases in value after purchase, increases income long term, or delivers a return greater than the interest cost, the loan is referred to as “good debt”. Many investments purchased with loans can fall under the category of good debt. This is typically called leveraging, and the loan itself is a margin loan.
Leverage increases the amount of capital that is used to purchase investments. If you use only your own money, interest earned increases based on your personal capital. If you use a margin loan, interest increases based on principal of your loan and your personally invested capital. Since the base amount of capital invested is not limited to your personal capital, the return earned is higher, but only under certain conditions.
The overall return kept is significantly higher. If you invested $10,000 of your own principal and it increased by $800, you would have gained an 8% return. If you invested $5,000 of your own capital and borrowing $5,000 your personal return would earn 16% before loan costs. As long as your interest rate was low, or the loan repaid before it could gain substantial interest, you could keep the 16% return instead of paying it as interest on the loan.
Your losses are also multiplied. If you lose, you will still have to pay the loan’s principal and interest cost. If you invested $10,000 and the investment decreased by $800, you’d lose 8% of your money. This changes if you borrowed half of the money. If you borrowed $5,000 of the $10,000 and lost $800 on the investment you would have to pay back the $5,000 loan. You will absorb the full loss; the bank won’t forgive you just because there’s no profit. You would lose $800, or 16%, plus loan fees if you repaid the lender immediately. If you repaid the loan slowly and let interest build, you would lose even more.
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