Promissory Note Investing Using Leverage-Borrowed Money

Leverage (borrowed money) is a powerful investing tool; it can increase yields and capital gains.

Leverage can also magnify losses. Use it with caution.

What is Leverage?

Money borrowed at a lower interest rate than the interest rate earned on the investment owned results in extra cash-flow-an extra profit. If you borrow at 3.5% and invest those funds at 7.0% you have created a leveraged investment producing a “spread” (profit margin) of 3.5% per year. Besides the extra annual cash-flow earned there is a possible capital gain to be earned if the investment can be sold for more than its purchase price.

Three Types of Leverage

Positive leverage–the example above is called “positive leverage”. It produces a positive investment result; it produces a profitable yield for the investor, and may also generate a capital gain upon the sale of the investment.

Neutral leverage-if the interest rate paid for the borrowed funds is the same rate as the investment earns, no extra cash-flow or extra yield is generated. Borrowing at 7% to invest at 7% does not generate extra cash flow, but, if the investment appreciates in value, and is sold for more than was invested, a capital gain is created. Neutral leverage is a tool for controlling an investment with the goal of eventual sale at a profit.

Negative leverage-if the interest rate paid for the borrowed funds exceeds the rate earned by the investment, no extra cash flow or extra yield is generated. Actually, a loss is generated-a negative cash-flow, a negative yield is created. The investor must pay money to the lender from his own funds to support the investment; this is called “feeding the investment”. The only positive result is the sale of the investment for enough to recoup the initial investment plus the “negative feed” paid during the holding period.

Leverage and Appreciation

Existing promissory notes are often sold by the party that originated them. The reasons for the sale vary; examples…

Source by Lawrence Tepper

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