Leveraging

A household can buy an asset with its savings. Or it can buy a bigger asset by adding a loan to those savings. The second choice is leveraging.

The appeal is simple. The gain is earned on the whole asset, but only part of the money was yours. So the return on your own money is larger.

The risk is the same sentence read backwards. A fall is also measured on the whole asset, while the loan has to be repaid in full. The interest has to be paid either way.

The workbook is careful about which assets this is used for. Loans taken to buy an appreciating asset such as a house add to long-term wealth. Loans taken to buy financial assets are riskier, because their prices move much more.

And there is a third kind of borrowing that is not leveraging at all — borrowing to pay the monthly bills. That is the start of a debt trap.

The workbook uses the word in two places, and they say different halves of the same thing.

Section 4.1 — the upside. The decision to use borrowed funds over own funds, also called leverage, may actually increase the return made on an investment. The workbook attaches a name to the idea: the Modigliani-Miller Theorem (M&M). Note the verb — may, not will.

Section 1.4 — the risk. Loans taken to buy appreciating assets add to long-term wealth. Loans taken to buy financial assets, also called leveraging, is risky because of the higher volatility in the price of such assets. Assets acquired with savings, and without taking on a liability, add to the financial strength of the household.

Section 4.3.1 — the worst case. Financing risky or volatile investment propositions with debt may put the entire financial security of the individual or household at risk. Margin financing for stock market investing is one such investment. A fall in the value of the investment will magnify the loss, since the cost of debt will also have to be accounted for.

How much is too much? Section 4.1 and 1.4 give no limit — no loan-to-value cap, no maximum borrowing. The workbook measures household leverage elsewhere, with the leverage ratio of section 3.9.4: total liabilities divided by total assets. Its own illustration there is Rs 13 lakh of liabilities against Rs 65 lakh of assets, i.e. 20%, and it warns that a ratio greater than 1 means the assets will not be adequate to meet the liabilities. That is the number to quote — and it belongs to the ratio, not to leveraging as a concept.

Illustrative figures. Arjun has Rs 5,00,000 to invest in equity. His broker offers to fund a further Rs 5,00,000 at 12% a year, so he can buy Rs 10,00,000 of shares.

One year later, two worlds:

Without the loan he would have owned Rs 5,00,000 of the same shares, and made +20% or −20%.

The leverage turned a 20% market into a 28% gain and a 20% fall into a 52% loss. It is not symmetric in his favour, and the reason is the Rs 60,000 of interest: it is payable in both columns. That is the workbook's point that the cost of debt has to be accounted for in the loss.

Now the case the workbook approves of. Arjun instead buys a Rs 60,00,000 flat with Rs 15,00,000 of savings and a Rs 45,00,000 home loan. Same mechanism, different asset: a house is an appreciating asset with far lower price volatility than a mid-cap share, and the loan is secured, so the rate is lower. His leverage ratio right after the purchase is high — the workbook expects exactly that immediately after a large-ticket purchase — and moderates as the flat appreciates and the loan runs down.

Chapter 1 (Introduction to Personal Financial Planning), section 1.4, names leveraging while describing how assets are acquired; Chapter 4 (Debt Management and Loans), sections 4.1 and 4.3.1, give the return argument with the Modigliani-Miller reference and the margin-financing warning. Expect a conceptual question: which kind of borrowing adds to long-term wealth, or why financing a volatile investment with debt is risky.

• This is not the derivatives sense of the word. In the derivatives papers, leverage means controlling a large contract value with a small premium or margin. Here it means buying an asset partly with borrowed money. Same word, different mechanism.
• The workbook says "may" increase the return. M&M is cited as the reason leverage can raise the return on an investment, not as a promise that it will.
• The asset decides the verdict. Borrowing for an appreciating asset adds to long-term wealth; borrowing for volatile financial assets is the risky case; borrowing for regular expenses is the debt trap.
• Interest is payable in the loss case too. That is why a leveraged loss is bigger than the market fall, not merely equal to it.
• Leveraging has no threshold of its own. The figures — 20% in the illustration, a ratio above 1 as the danger line — belong to the leverage ratio in section 3.9.4.
• Do not confuse it with the debt to income ratio. Leverage is about the balance sheet; DTI is about whether monthly income can service the borrowing.
• This is borrowing, not the derivatives sense of leverage. Series VIII's leverage is controlling a large contract value for a small outlay — an option premium or a futures margin — with no loan involved. Here you actually take on debt, and owe it back whichever way the asset moves.