The power of leveraging
If you've read the title of this piece and don't know what leveraging is then don't worry, you are far from alone. Yet interestingly while most people don't know much about leveraging the reality is that most people use it. Bear with me as I'll explain.
Buy-to-let is one of the most emotive subjects I write about. Whenever I write about a topic or an investment I always focus on the facts and try to give a balanced view. Now, I won't pretend to be a huge fan of buy-to-let as an investment but that's based purely on crunching the numbers. The reality is that unless you are buying without a mortgage the returns on buy-to-let just aren't that attractive once you factor in all the costs involved. The situation is going to get even worse when the new stamp duty on second properties is brought in next April.
Yet I often receive correspondence from people questioning my maths. The correspondence usually goes along the lines of 'ah, but let's say I invested £30,000 into a buy-to-let with a £270,000 mortgage. If the house was worth £300,000 and I sold it for £330,000 I'd have made £60,000 profit or in other words doubled my money, a 100% profit!'
If I ignore the fact that they've overlooked costs such as stamp duty then in simple terms they are right. But the scale of the profit is a function of the fact they borrowed money (from a bank) for a fee in exchange for not having to share any profits (or losses) with the bank. That is called leveraging. The property grew 10% in value not 100%. Also if someone had borrowed a different amount of money and bought the property their percentage return would be different. If it were possible to borrow £299,000 I would have made a 3,000% profit.
The scale of the profit says everything about the power of leveraging (i.e it can amplify your profits) and not too much about the asset you bought. In this week's podcast I explain in more detail with a neat example. If I used the same example above but instead of buying a buy-to-let property the person bought shares in Company X at £1 each. You can quickly see that you would replicate the same profit if the share price rose in value by 10p to £1.10. Your supposed 'profit' of 100% says nothing about whether other people would receive a similar rate of return. It also says nothing about how good company X shares are as an investment. If I told you that share price of its peers rose by 20p to £1.20 your profit isn't looking all that clever is it? In fact you've actually bought the worst company in its sector yet lucked out that its shares rose off the back of its peers.
Yet what people forget is that leveraging can work the other way and amplify your losses, while your debt remains due.
Everyone who has a mortgage is using leverage. But because we look beyond the mortgage (we see it as just part of buying property) we don't associate any of the returns as being a result of it. Ask someone to list their debts and most would list credit cards but not their mortgage 'because that doesn't count'.
The problem is that when it comes to attributing the profits from property it appears that the mortgage 'still doesn't count'. We can debate the intricacies of tax reliefs of buy-to-let versus other asset types but that misses the point, especially as a number of buy-to-let's tax perks are now under attack from the Chancellor.
So there two questions I want to leave you with and I want you to answer them honestly.
- Would you borrow £270,000 to make an investment in another type of asset (not property), based on the fact that everyone else says it's the right thing to do?
- Would you stick your head in an oven because everyone else tells you it's the sensible thing to do?
Right, cue the angry comments...
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