Thursday, September 27, 2007

What Is Leveraging?

Copyright © Michael Laleye

Leveraging is a recent investment strategy which is more or less unpopular with the mainstream investing public. While most think they have heard everything about leveraging, they are mistaken.

Most people indeed have a negative perception when it comes to leveraging. This is because, often, the only time people hear about leveraging is when the strategy fails. However, leveraging can be a success when used properly.

Leveraging is a strategy employed to buy financial assets with borrowed funds with the goal of increasing profits. A common example of leveraging is getting a mortgage to buy a house. In that scenario, you are borrowing money to buy a house in the hopes that you could sell it for a profit (after the interests are deducted) at a later date. This is how leveraging works. You borrow money and invest it.

As in all money making strategies, leveraging can be very risky. Most even think it is an unwise practice. But when used wisely, leveraging can be very profitable. In fact, some businesses and individuals even talk about making a fortune due to leveraging. The biggest hurdle that you would face as an investor would be interest rates. Shaky interest rates may add to your profits or losses.

There are a number of good examples on how you can benefit from leveraging. The most basic is through investment loans. You borrow funds and invest it in the hopes that the profit would be bigger than the accumulated interest. In some countries such as Canada, one can deduct the interest paid on loans for some investments. This makes leveraging much more appealing to an investor since interest rates would no longer be a factor in coming up with a profit.

Another is the RRSP loans. RRSP or registered retirement savings plan is a vehicle available to people to defer tax on a particular amount of money to be used for retirement. The individual invests money in one or more of a variety of investment vehicles which are held in trust under the plan. Income tax is deferred until the money or the amount originally deposited (plus any interest or dividends made from that money) is withdrawn at retirement age. This means that there are two advantages when you borrow to invest in your RRSP. One, your larger contribution is tax deductible. Second, your investment in protected from tax.

There are many leveraging strategies. Some are quite fundamental and does not require much knowledge on finance but others are very sophisticated and require a certain level of advanced knowledge. As in most investments, prudent planning must be ensured. Moves must be calculated. After all, leveraging is definitely not for everybody. In the end, only you can decide if leveraging is for you.

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