For a long time, many businesses owed a big part of their success to a simple financial concept: leverage. By borrowing money cheaply and earning superior returns on their capital, businesses multiplied their profits.
But as the financial crisis in 2008 showed, leverage-driven businesses brought the markets to the brink of collapse. With that recent history as context, is taking on leverage in your personal finances a good idea, or does it leave you open to too much risk?
Mimicking dividend leaders
It's common sense that when interest rates are low, it makes sense to borrow money. For instance, with mortgage rates at record lows and home prices relatively low, it's been a long time since homes were more affordable than they are now, at least in terms of how much you'll pay in monthly payments. Moreover, leverage-driven businesses like mortgage REITs Annaly Capital (NYSE: NLY ) and American Capital Agency (Nasdaq: AGNC ) have thrived from the low-interest-rate environment, taking advantage of an upward-sloping yield curve to borrow cheaply and earn greater income on mortgage-backed incomesecurities.
Yet borrowing to lever up your personal investment portfolio can potentially involve a lot more risk to your finances. Conceptually, buying stocks on margin isn't much different from using leverage to buy a home, but in practical terms, the practice raises much more dire concerns, with reminders of past financial calamities resulting from overuse of margin.
It can be done...
Thanks to advances in the online brokerage industry, it is possible to make prudent use of margin. Many brokers still charge ridiculously high margin rates of 8% or more on relatively small loan balances. But if you shop around, you can find some discount brokers that currently charge less than 2% on outstanding margin loans.
With such low margin rates, it's easy to find investments that will provide enough cash flow to cover interest payments. There's no shortage of blue chip dividend stocks that yield more than 2%, and you can even find many corporate bonds that will pay you enough to cover margin interest.
...but at a price
The problem, though, comes from the impact that borrowing on margin can bring. As a research paper (link opens PDF file) cited in a recent Wall Street Journal article discusses, leverage introduces its own unique risks, most notably the risk that temporary adverse market conditions will trigger margin requirements that necessitate immediate liquidation of assets to repay the loan.
Countless stories show the magnitude of margin-call risk. Chesapeake Energy (NYSE: CHK ) CEO Aubrey McClendon suffered one of the most famous margin calls in industry, losing almost his entire $2 billion stake in the company after plunging energy prices pushed Chesapeake stock down sharply. General Growth Properties (NYSE: GGP ) president Bob Michaels had a similar experience, selling more than 1 million shares in the span of only a couple of months during the financial crisis. More recently, former Green Mountain Coffee Roasters (Nasdaq: GMCR ) board chair Robert Stiller and lead director William Davis were booted from their board leadership positions after having to liquidate positions in violation of internal trading policies due to margin loans.
Making the choice
Despite the dangers involved, prudent use of margin isn't automatically a bad thing. As a way of providing short-term financing, it can be much more efficient and less expensive than tapping other sources of funds.
For longer-term purposes, though, you need to make sure you're paying 2% and not 8% if you're going to go the margin route. Overcoming an 8% hurdle under current market conditions is difficult, and if shopping around can save you 6 percentage points, it's worth the effort on loans of any significant size.
Perhaps the most important thing about margin is never to overuse it. History is littered with countless tales like the ones described above in which investors were far too confident about their stocks' prospects. Using margin can potentially take away one of your biggest advantages as an investor: the ability to be patient even through hard times.
Margin loans can get you better results in a low-interest-rate environment. But don't look at margin as a way to get rich quick. If you make that mistake, you'll greatly increase your chances of a huge loss.
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