This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
Leverage, used carefully, can be a useful tool for managing liabilities in a stock portfolio. The investor borrows against the portfolio to fund a liability, and the investor keeps the portfolio invested. The trade-off is the cost of the borrowing, the risk of a margin call, and the potential for the leverage to amplify a market downturn. The investor should understand the mechanics and the risks before using leverage to manage liabilities.
What "managing liabilities with leverage" means
The phrase covers several scenarios. The first scenario is the use of a margin loan to fund a large purchase, like a house down payment, while keeping the stock portfolio invested. The second scenario is the use of a leveraged position to hedge an existing liability, like a short position on a stock the investor already owns. The third scenario is the use of options to generate income against a long stock position, and the income is used to pay a liability.
Each scenario has a different risk profile, and each scenario requires a different level of sophistication. The investor should match the scenario to the investor's expertise, and the investor should not use leverage for a scenario the investor does not understand.
The main advantages
The first advantage is the opportunity cost. The investor who sells the stock portfolio to fund a liability gives up the future returns of the portfolio. The investor who uses leverage keeps the portfolio invested, and the investor captures the future returns. The trade-off works in the investor's favour when the portfolio returns are higher than the borrowing cost.
The second advantage is the tax efficiency. In some jurisdictions, the interest on a margin loan is tax-deductible, and the interest is not taxed until the position is sold. The investor should check the local tax rules, and the investor should consult a tax advisor before using leverage for tax efficiency.
The third advantage is the flexibility. The margin loan can be drawn as needed, and the loan can be repaid at any time. The investor has full control over the loan size and the repayment schedule. The flexibility is useful for investors who have irregular liabilities, like a renovation or a tax bill.
The main drawbacks
The first drawback is the margin call. The broker can demand additional funds if the portfolio value falls below the maintenance margin. The investor who does not have the additional funds has the portfolio liquidated at the worst possible time, and the investor realizes the loss. The margin call is the main risk of using leverage, and the investor should keep a cash buffer to avoid the call.
The second drawback is the interest cost. The margin loan charges an interest rate, and the interest is paid regardless of the portfolio's performance. The investor who uses leverage pays the interest even when the portfolio is down, and the interest adds to the loss. The interest cost should be compared to the expected portfolio return, and the leverage should not be used if the expected return is lower than the interest cost.
The third drawback is the loss amplification. The leverage that produces a 5 percent gain on a 5:1 position can produce a 5 percent loss, and the loss can be larger than the gain because of the spread, the commission, and the financing charge. The investor who uses leverage can lose more than the initial deposit.
The fourth drawback is the psychological pressure. The leveraged position can be stressful, and the investor may be tempted to sell at the wrong time. The investor who cannot handle the pressure should not use leverage, and the investor should consider a smaller position or a different strategy.
When the leverage makes sense
The leverage makes sense when the borrowing cost is lower than the expected portfolio return, when the investor has a cash buffer to cover a margin call, and when the investor has a long time horizon.
The leverage does not make sense when the borrowing cost is higher than the expected portfolio return, when the investor does not have a cash buffer, or when the investor has a short time horizon. The leverage also does not make sense for investors who are close to retirement, and the leverage does not make sense for investors who cannot afford to lose the portfolio.
Risk management rules
The first rule is to size the loan to the cash flow. The investor should choose a loan size that the investor can service with the cash flow from the portfolio or from the salary. The loan should not be sized to the maximum the broker allows, and the loan should be sized to a level the investor can service even in a downturn.
The second rule is to keep a cash buffer. The investor should keep 6 to 12 months of loan payments in cash, and the cash should be in a separate account. The buffer protects the investor from a margin call during a temporary market downturn, and the buffer gives the investor time to top up the account.
The third rule is to monitor the margin level. The investor should check the margin level regularly, and the investor should set an alert at 30 percent above the maintenance margin. The alert gives the investor time to act before the broker sends a margin call.
Common questions about leverage and liabilities
Can I deduct the interest on a margin loan? In some jurisdictions, yes. The investor should check the local tax rules, and the investor should consult a tax advisor before using leverage for tax efficiency.
What is the typical interest rate on a margin loan? The interest rate depends on the broker and the jurisdiction. The rate is usually 1 percent to 3 percent above the central bank rate, and the rate can be higher for small accounts. The investor should compare the rate across brokers.
Can I lose my house if the margin call fails? The margin loan is a recourse loan, and the broker can pursue the investor for the difference if the loan exceeds the portfolio value. The investor should not use leverage for a liability the investor cannot service, and the investor should keep a cash buffer.
Related resources
Where to start
If you are evaluating leverage to manage liabilities, the most useful first step is to calculate the borrowing cost and the expected portfolio return, and to compare the two. Our broker comparison lists the brokers that offer margin loans and the interest rates, which together tell you what the broker offers before you take the first margin loan.