The secret to building wealth lies in leveraging your money and using debt. I forgot where I heard this, but with my background in real estate, I 100% agree that the use of debt can dramatically change your financial situation for better or worse.
In basic real estate investing 101, we’re all taught to use mortgages to buy investment properties worth multiple times the cash we have on hand and use rental income to cover mortgage payments while generating bonus income every month.
For example, you might buy a $600k house with a $120k down payment and take a $480k mortgage. With a 3-year fixed rate of 5.59% and an amortization period of 30 years, monthly mortgage payments will equal $2733.22. Add in property taxes and home insurance costs (I’m in Calgary, so taxes were calculated here, and I used average home insurance cost data from this website), which would be another ~$500 per month.
In total, you would be paying about $3200 every month.
Real estate investing is great because you’re supposed to then find tenants and charge them, perhaps, $3500 a month. This way, you’ll pay all your expenses while having a little bit of extra spending cash.
Since rental income covers all your expenses, you basically 5Xed your initial $120k down payment by buying a $600k home using a mortgage. We haven’t even considered appreciation and the cash flow you’ve been getting yet.
The ability to significantly leverage your money in real estate is one reason people continually quote real estate as the best investment you can make.
Of course, real estate investing doesn’t always go according to plan. Things may and probably will go wrong.
One disadvantage of real estate is the barrier of entry. Unless you’re planning to invest in obscure neighborhoods using risky debt strategies, you need a good amount of starting capital and the ability to qualify for mortgages to get going.
A guideline our mortgage broker told our family was we can borrow ten times our annual salary with a 20% down payment. That means to buy a $400k piece of real estate, you’ll need $80k on hand and be making at least $32k a year, preferably. Again, what you can borrow and buy will heavily vary depending on your situation and where you live.
Real estate’s high barrier of entry raised new questions. How and what can I invest in that doesn’t require a significant amount of capital? One option would be the stock market.
You can use various stock market investing strategies, such as value investing, growth investing, and more. As I looked at stocks and talked to different friends about what they were buying, I eventually came across the dividend investing strategy, where people bought stocks and ETFs for their dividend yield.
I was surprised to see people with holdings that yielded more than 10% in dividends. Additionally, I learned that many of these holdings also pay dividends monthly. This started a train of new thoughts.
What if someone uses margin loans to buy high-yielding dividend stocks the same way we use mortgages in real estate investing? If I buy a stock that yields 10% annually using a margin loan at a 5% rate, I should be able to cover my loan payments with the monthly dividends, right?
A Hypothetical Scenario And Doing The Math
I remember one time as a kid, I asked my parents what buying stocks on margin meant. They answered my question and followed it up with an immediate, “Never, ever invest using margins.”
That stuck with me, but in a good way. It’s a good thing I didn’t decide to test my dividend-margin theory with real money right away.
The “never touch margins” advice isn’t good advice, though. As I grew up and matured, I learned that most things in life are never black-and-white cases where the answer is simply yes or no.
My parents had told me not to use margins as my dad had previously lost a significant amount of money shorting stocks which was completely understandable that they would want me to avoid the same fate.
After entering the luxury real estate industry and seeing ultra-high-net-worth individuals buy multi-million dollar homes entirely from a margin loan, I realized how powerful debt could be when used correctly.
So instead of saying no to buying high-yielding dividend stocks using margin loans, I did some initial math to help myself assess whether the extra growth from the margin loan was worth the risk.
I created a hypothetical situation where my annual dividend yield was 10%, and the dividend was paid monthly. I used the 6.33% margin rate referencing the IBKR Lite rate and decided to start with $200k in cash and borrow $100k.
Here’s a graph comparing a situation where I bought an extra $100k worth of dividend stocks using margin vs. just cash.
In this line graph, you can see the gap between the two lines widening ever so slightly toward the end. It shows that even with the monthly interest payments, buying dividend stocks on margin will grow your account balance faster than just using cash.
I’ve also included a table below with multiple data points that will allow us to better compare the results of using margin versus cash.
When calculating the margin balance for every month, I took the former month’s balance, multiplied it by the dividend yield, and divided it by 12 to get the monthly dividends paid. Then I subtracted $527.50 (monthly interest payment on a 6.33% $100k margin loan) from the monthly dividend and added the number to the former month’s balance to get the current month’s balance.
E.g., Month 72 = ((Month 71 * 10%)/12 – $527.50) + Month 71
The cash balance is a more straightforward calculation as it does not involve paying monthly interest. Simply calculate the dividend paid and add it to the previous month’s balance.
E.g., Month 120 = (Month 119 * 10%)/12 + Month 119
Finally, for the “Income Difference After Paying Back Principal” category, the calculation is done by subtracting $100k (paying back the loan) and the cash balance from the margin balance. This metric demonstrates the extra profit you make by buying stocks on margin.
E.g., Income Difference After Paying Back Principal = Margin – $100k – Cash
The Risks
Undoubtedly, if you can earn enough money from dividends to pay off a loan’s monthly payments, plus more, you will make more money by using margin than just using cash. However, that’s a big “if.”
There are multiple catches with using margins to buy dividend stocks:
- Dividend payment fluctuation
- Stock price fluctuation
- Margin loan interest rate changes
As you can see from the charts, this strategy works better the longer you can defer paying back your loan principal. Unfortunately, the longer you hold onto a stock using margin, the more risk you take.
The problem with margin loans is that they’re based on the value of your account. If your stock holdings fall below certain thresholds set by the brokerage (often 25% – 35% of the loan you take out), you can incur a margin call where the brokerage has permission to sell your stock holdings without consulting you first.
The problem with the stock market is that it’s very volatile. Even the best stocks could cut their dividends and lose all their value due to unforeseeable circumstances. You increase the risk of facing unforeseeable circumstances the longer you hold onto a stock.
So yes, you’ll make more money buying stocks with dividend yields higher than the margin rate of a loan you take out, but you need to be very aware of how much you can afford to lose. Using margin will amplify your gains, but it will also amplify your losses.
