However, if you borrow an additional $400,000, a 10-per-cent gain will return an additional $40,000. So you gain a total of $50,000, which is a 50-per-cent return on your original equity investment of $100,000.
Often these investments are structured so that the investment income (or in some cases a return of capital) is used to make the loan payments. The idea is that, even if the market dips, the investor will have enough cash to service the loan, and can sit tight until the market rebounds.
There are also tax benefits. Any loan acquired for investment purposes is tax deductible.
It adds up to a very seductive investment opportunity, but it has a very ugly flip side. Using the same example, if the market declines by 10 per cent, you will lose a total of $50,000, which is half your original equity investment. And you still owe the bank $400,000.
That's a very scary proposition. As we have seen in recent years, market downturns can be very wrenching. If the investor does not have the nerve or the financial capacity to with-stand the heat, he will bail out, crystallizing some very heavy losses.
Of course, the loan remains and the ongoing debt servicing requirements can seriously compromise the investor's life-style. If the investor is unable to make the payments, the lender will most likely realize on the security, which often includes the family home.
In my view, it is a strategy that is appropriate for only the wealthiest and most sophisticated of investors. How-ever, most people who invest in mutual funds are not market savvy. They are generally people who want other people to manage their money, even though they are almost certain to get below-market returns. For the latest updates on the stock market, visit Stock Market Today For the latest updates PRESS CTR + D or visit Stock Market news Today
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