Investing in financial markets and real estate can be exciting, but it's important to be aware of the risks associated with leveraging your investments through margin accounts and mortgages. While mortgages are commonly seen as a safe way to invest in real estate, it's crucial to recognize the inherent risks in this form of leverage.

With mortgages, individuals borrow a significant portion of a property's value and make regular payments consisting of principal and interest to repay the loan. For example, an individual may place a 20% down payment and borrow the remaining 80%. This leverage allows one to benefit from the full property's appreciation even though they only committed a relatively small down payment. However, mortgages come with risks. When interest rates rise or real estate prices decline, those who have borrowed extensively may face foreclosure or a 'power of sale'. Strategies like negative amortization or extending the amortization period can delay foreclosure, but may only provide temporary relief depending on the length of the higher interest rate cycle.

Currently, as interest rates reach trigger points (a specific threshold where the monthly payment on a mortgage is no longer sufficient to cover the interest portion of the loan), many mortgages are facing challenges. Property owners with negative cash flows and negative equity are finding it difficult to cover ownership costs and loan repayments. These situations underscore the dangers of overleveraging and the potential for significant financial losses.

Similarly, margin investment accounts leverage existing funds to further invest in financial assets. Investors can typically borrow up to 50% of an investment's value, enhancing their buying power and potential returns. While margin accounts and mortgages share similarities in their purpose of leveraging investments, they have crucial distinctions. A key difference is the immediate ‘margin call’ in the margin account when the investment value declines and the outstanding loan amount breaches the limits permitted. Investors must deposit additional funds or sell securities to ensure the proportion of borrowed funds to account size is back within limits. In contrast, mortgages often have a delay in the foreclosure process, even with declining property prices and excessive borrowing. Still, this temporary relief does not eliminate the consequence of a foreclosure or a power of sale.

In our view, mortgages pose a higher risk than commonly realized. Mortgages do not benefit from a built-in discipline of margin calls that serve as a ‘pulse check’ on one’s borrowing and rebalance the proportion of the outstanding loan balance. Mortgages also typically have higher borrowing limits than margin accounts (traditionally 80% for mortgages vs 50% for margin). The higher leverage allowed in mortgages and the delay in the foreclosure process can tempt individuals to borrow beyond their repayment capacity, amplifying both gains and losses.

Regardless of the investment type—stocks, bonds, or real estate—understanding the risks associated with leverage is crucial. Prudent borrowing decisions and a high level of confidence in repayment capabilities are essential. Overleveraging through margin accounts or mortgages can lead to financial distress and significant losses. It's important to approach leveraged investing with caution, considering one's financial capacity to handle adverse scenarios.