Leverage breakeven point: lower than you think

Leverage -- borrowing to invest -- is controversial because, like a power tool, leverage can produce both tremendous gains or damage, depending on how it is used.

Understanding the real breakeven point of leverage is critical because mathematically, the breakeven point of any investment strategy defines the risk of that strategy.

Most people reasonably think that their investment returns must exceed their cost of borrowing for leverage to be profitable. This is not true for several reasons, beyond the tax benefits of interest deductibility and only paying tax on three-quarters of capital gains.

Straight line vs. curved line. Let's assume that you pay 10% interest to borrow $10,000. Your interest expense for year one is $1,000, the same as for year 2, year 9, etc. Thus, the total interest cost increases by the same amount each year.

Technically, debt interest charges are called simple interest because they are the same every year. When graphed, the total borrowing cost produces a straight line.

However, investments compound, with interest on interest. This compound interest when graphed produces a curved line.

This subtle distinction -- that debt is simple interest with a straight line cost while investments compound with a curved line -- has huge implications.

Even ignoring the tax benefits, you do not need to even clear your cost of borrowing to break even. In addition, the breakeven point for leverage decreases over time.

Next month we will quantify how low the real breakeven point is, and how it -- and hence your risk with leveraging -- decreases over time.

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