When asset prices rise strongly, a new option appears: borrowing against the gain. Homeowners whose properties have risen in value can increase their mortgages. Investors whose portfolios have grown can borrow against them. Business owners can use rising property values to secure larger loans. In each case, the extra money can fund spending, more investment or business expansion.
This is leverage: using borrowed money to increase the size of a position or to fund spending beyond current income. Leverage is not inherently bad. Used carefully, it can help households buy homes, businesses grow and investors build wealth. But leverage magnifies both gains and losses, and leverage taken on during a boom, against inflated asset values, is among the most common ways people and businesses come to grief when the boom ends.
This article explains how people borrow against rising assets, how leverage magnifies outcomes, why borrowing during a boom is especially risky, and how to use leverage more safely. It is part of GoCore’s series on bubbles.
How people borrow against rising assets
Mortgage equity withdrawal
For most households, borrowing against assets means borrowing against the home. This is often called mortgage equity withdrawal: releasing some of the increased value of a property by:
- increasing an existing mortgage or using a redraw facility
- refinancing to a larger loan with a new lender
- taking a line of credit secured against the home
Over recent decades, borrowing against home equity has become much easier in many countries, as lending rules have been relaxed and products have multiplied. The money released may fund renovations, cars, holidays, education, other investments or a business.
Borrowing against shares
Investors can borrow against shares through margin loans, which let them buy more shares using their existing portfolio as security. If the value of the portfolio falls below a set level, the lender issues a margin call, requiring the investor to add cash or sell shares.
Other products provide leverage without a traditional loan. Contracts for difference allow traders to gain exposure to price movements by putting up only a fraction of the value. Leveraged exchange-traded funds aim to deliver a multiple of a market’s daily return. These products can produce large gains or losses quickly and are generally suited only to experienced investors who understand them well.
Buying more assets with borrowed money
A common response to rising wealth is to buy more of the rising asset, for example by buying an investment property using equity in the family home as the deposit, with a new mortgage for the rest. The household’s total assets rise, its debt rises, and its overall wealth after debt may not change at all. What changes is its risk: it is now more exposed to the asset whose price has already risen.
Businesses borrowing against assets
Businesses often borrow against property or equipment, and many small businesses are funded by loans secured against the owner’s home. When property prices rise, borrowing capacity rises with them. Business owners may use that capacity to expand, buy premises or fund working capital.
How leverage magnifies outcomes
Leverage works through simple arithmetic. When part of an asset is financed by debt, any change in the asset’s value falls entirely on the owner’s equity.
Consider an illustrative investment of $500,000 in each of three ways.
| No debt | 50% debt | 80% debt | |
|---|---|---|---|
| Owner’s money | $500,000 | $250,000 | $100,000 |
| Borrowed | $0 | $250,000 | $400,000 |
| If the asset rises 20% | +20% on equity | +40% on equity | +100% on equity |
| If the asset falls 20% | −20% on equity | −40% on equity | −100% on equity |
(For simplicity, the table ignores interest costs, which reduce gains and deepen losses.)
With 80% debt, a 20% rise doubles the owner’s money. A 20% fall wipes it out entirely. Leverage turns modest price movements into very large changes in wealth.
Interest costs
Borrowed money is not free. Interest costs reduce the return on a leveraged position. If an asset earns less than the interest rate on the loan, after allowing for any income it produces, leverage reduces returns even when prices are rising slowly. In a boom, rapid price gains easily cover interest costs. When prices stop rising, interest continues, and leveraged owners can find that their asset costs more to hold than it earns.
Why boom-time leverage is especially risky
Borrowing during a boom combines several risks.
Borrowing against inflated values. The security for the loan has been valued at boom prices. If prices fall back to more normal levels, the debt may exceed the asset’s value.
Lenders are generous. During booms, lenders compete and loosen standards, offering higher loan-to-value ratios and larger loans relative to income. The amount a lender will offer can far exceed what is prudent.
Expectations are high. Borrowers expect prices to keep rising, which makes high debt seem safe. If expectations prove wrong, the plan built on them fails.
Interest rates may rise. Booms often end with rising interest rates. Borrowers who stretched to the limit at low rates face sharply higher repayments.
Incomes may fall. Busts bring job losses and weaker business conditions. Borrowers who rely on income to service debt may lose it just when asset values are falling.
Forced selling. Margin calls, loan covenants and repayment pressure can force leveraged owners to sell at the worst possible time, often at a loss larger than their original equity.
Leverage in past bubbles
Leverage has played a central role in many of history’s best-known bubbles, though its form has changed over time.
During the British Railway Mania of the 1840s, investors could often buy railway shares by paying only a small deposit, with the remainder payable later when the company called for it to fund construction. When the calls came, many investors who had bought far more than they could afford were forced to sell, accelerating the collapse.
In the US share boom of the late 1920s, buying shares on margin was widespread, with investors commonly putting up only a fraction of the purchase price and borrowing the rest from brokers. When prices fell in October 1929, margin calls forced selling that deepened the crash.
Japan’s late-1980s bubble was fuelled by bank lending secured against land and shares, whose inflated values supported ever-larger loans. When prices fell, the security behind those loans shrank, leaving banks with bad debts that took many years to resolve.
The US housing boom of the 2000s relied on mortgages with small deposits, low introductory rates and loose checks on borrowers’ incomes. When rates reset higher and prices fell, many borrowers could neither repay nor sell.
In each case, leverage allowed prices to rise further than savings alone could have pushed them, and forced selling made the fall sharper.
Negative equity
When the value of an asset falls below the debt secured against it, the owner has negative equity. Negative equity is particularly damaging because it traps borrowers:
- They cannot sell without paying the shortfall from other resources.
- They may struggle to refinance, because lenders will not lend more than the asset is worth.
- They tend to cut spending sharply to keep up repayments, weakening the wider economy.
Widespread negative equity was a central feature of the US housing bust that began around 2006–07, and of earlier housing busts in the United Kingdom in the early 1990s.
The effect on spending and the economy
When households borrow against rising assets to fund spending, consumer spending rises faster than income and the household savings rate falls. The article Wealth effects explains why this boost to spending is temporary: unless the borrowing is repeated, and increased, spending growth falls back. When asset prices stop rising and equity withdrawal stops, spending can fall sharply.
On a large scale, this makes the economy more vulnerable. High household debt magnifies the effect of rising interest rates and falling asset prices, and turns a correction in asset prices into a broader slowdown.
Using leverage more safely
Leverage can be used sensibly. A few principles reduce the risk.
Borrow against normal values, not boom values
When deciding how much to borrow, consider what the asset might be worth in an ordinary market rather than at its current price. If the debt would still be manageable if prices fell back to longer-term norms, the borrowing is more robust.
Test repayments at higher interest rates
Calculate repayments at interest rates several percentage points above current levels. If the household or business could not cope, the loan is too large. Australian lenders are generally required to assess borrowers’ ability to repay at a rate above the loan’s actual rate, but setting your own, more conservative buffer is prudent.
Keep income and asset risks separate
Borrowing against an asset whose value depends on the same factors as your income doubles the risk. A builder who borrows heavily against investment property in the same city depends on the local housing market for both income and wealth.
Avoid funding spending with debt
Borrowing to fund consumption, such as holidays or cars, using home equity creates debt without creating an asset that produces income. It also tends to reverse: the spending happens once, and the debt remains.
Understand margin and covenant terms
For margin loans and business loans, know exactly what triggers a margin call or covenant breach, and keep a comfortable buffer. Forced selling at the bottom is how temporary price falls become permanent losses.
Keep reserves
Cash reserves allow borrowers to meet repayments through a period of lower income or higher rates without selling assets.
Leverage in business decisions
The same principles apply to businesses.
- Expansion financed against property can turn a downturn in the property market into a crisis for the business.
- Acquisitions financed with high debt at boom prices leave little room for error if earnings fall.
- Equipment purchased on finance during a demand peak can become a burden when demand falls.
GoCore’s article Debt as a warning light suggests measuring borrowing capacity in years of earnings rather than in what lenders will offer. During a boom, it is worth using normal-year earnings for that calculation.
A worked illustration
This is an illustration with round numbers.
A business owner’s home has risen in value from $800,000 to $1.2 million during a property boom. The mortgage is $300,000. A lender offers to increase the loan to $900,000, releasing $600,000 for the owner’s business expansion and an investment property.
The owner tests the proposal:
- If prices fell back 20%, the home would be worth $960,000 against a $900,000 loan: very little equity left.
- If interest rates rose 3 percentage points, repayments would rise sharply, at a time when the business might also be under pressure.
- If the business slowed, both income and the ability to service the loan would suffer together.
The owner instead borrows $150,000 for a carefully defined expansion with clear expected returns, keeps the rest of the equity untouched, and builds a cash reserve from business profits. When property prices later soften and interest rates rise, the household and business remain comfortably able to meet their commitments.
Common mistakes
Borrowing the maximum a lender offers. Lender generosity peaks in booms.
Valuing security at peak prices. Plan for prices returning to normal.
Assuming interest rates will stay low. Test repayments at higher rates.
Using home equity for spending. The spending ends; the debt remains.
Concentrating risk. Borrowing against an asset tied to the same factors as your income doubles exposure.
Questions to ask
- What would the loan look like if the asset fell back to its long-run value?
- Could repayments be met if interest rates rose by three percentage points?
- What would trigger a margin call or covenant breach, and how close is it?
- Is the borrowing funding an income-producing asset or consumption?
- For your own business: how much of your funding depends on property values that have risen during a boom?
Bringing it together
Rising asset prices create the opportunity to borrow against them, through mortgage equity withdrawal, margin loans, leveraged products or business loans secured against property. Leverage magnifies gains and losses, and borrowing during a boom is especially risky, because loans are secured against inflated values, lenders are generous, interest rates may rise and incomes may fall when the boom ends.
Leverage can be used safely by borrowing against normal rather than boom values, testing repayments at higher interest rates, avoiding debt-funded spending, understanding loan terms and keeping reserves. The goal is to make sure that a fall in asset prices, which will eventually come, is an inconvenience rather than a catastrophe.
Sources: an introductory chapter on asset bubbles written in the mid-2000s and widely documented financial history. Figures in the illustrations are not data and ignore taxes and fees. Lending rules change; check current requirements with a qualified adviser. This article is general information, not financial, lending or investment advice.
