Hourly Based Fee
Only Advice
Call today to arrange a meeting.
1 (902) 393-1248
P.O. Box 1201     Charlottetown, PE     C1A 7M8
T: (902) 393-1248 (direct)     CorkumFinancial@pei.sympatico.ca     www.CorkumFinancial.ca

Borrowing to Invest and Higher Risks – Is it for You? (Leveraging)

In this article, I discuss borrowing to invest.  The article is long, but understanding the concept and especially the risks is important.  Please take the time to read the entire article if you plan to follow this strategy.

What is “Leveraging?”

Borrowing money to invest is called leveraging. Remember your high school science, where you were taught that you can lift a heavier weight by using a lever – this was called leveraging.  In finance, the lever is using someone else’s money.

The old saying of “it takes money to make money” is at work here. You get your money by borrowing it.  A person borrows all or a portion of an amount to be placed in an investment. To the extent that the after-tax interest rate on the loan is lower than the after-tax rate of return on the investment, you can increase your wealth much faster by using borrowed capital.

How do I Make Money by Leveraging?

Effectively, leverage magnifies the rate of return on an investment. Simply put, you have more money to invest if you use other people’s money.

Assume you borrowed $100,000 and invested it all. After a $10,000 net increase in value (after interest expense and taxes), you have profited by $10,000 because you used someone else’s money. You would not have had the money to do this without their loan, and so you are richer because of borrowing.

Having said all that, you can make money by leveraging if you choose the right investment and have the correct discipline.  You must meet some other suitability guidelines also, some of which will be discussed below.

Fully understand the risks before borrowing to invest! 

It is important to emphasize again that leverage magnifies returns. Just as profits are magnified, if you have negative after-tax returns, your losses will also be greater than if you had not borrowed any money. This is because your loan interest and principal must still be repaid in full plus interest, but the value of your investment has declined.

In my example above, if the $10,000 was a decline in value, you would have a $90,000 investment offset by a $100,000 loan.  You are now $10,000 poorer.  Selling the investment will leave you with a $10,000 loan which, of course, must be repaid with interest.

a) What assets are you placing at risk?

Some people use of their home as collateral for the investment loan.  In such cases, if your house goes down in value and you cannot renew your mortgage for the same amount in the future, you may need to sell investments to repay the loan.  If the stock market is down at that time, you will incur investment losses.

If you are using your investment portfolio as security for your loan, will you be forced by the lender to repay some of the loan if the stock market declines? Will you have to sell some investments to do this? If so, this increases your risk. You have to sell at a loss, and you will lose the opportunity to share in the future  stock market recovery. Surviving the market downturns is an important feature of long-term investing, and leveraging is only appropriate for long-term investors.

If interest rates rise, the income being generated by your investment portfolio may not be enough to pay your mortgage payment.  If you are not relying on investment income to pay your loan (and you should not), you may not have enough other income to make your loan payments.  This can create cash flow problems for you, and in the worst case scenario, could result in a mortgage foreclosure on you home.  If your house value and mortgage payments stay the same, but the stock market crashes and your investments reduce their dividends, this can also create cash flow problems.

Plan for these events before you use a leveraging strategy.

b) Are you buying the right investments?

The decision on whether to use leveraging for investment purposes depends on the confidence that you have in the long-term quality of your investments, their income yield and their future growth in value.  For a leveraging strategy, you generally need to be in the stock market, not the fixed income security market.  Interest income on guaranteed investment certificates and bonds will not likely be higher than the loan interest you will pay.

If you look at the long-term historical trend of the stock market, you will see that it has risen with lots of temporary declines along the way.  If you are a long-term investor, buy a well-diversified portfolio of blue chip companies.  If you do not sell your securities when the market temporarily drops, you have a very good chance of making money from leveraging.  However, you need to understand that looking at a stock market trend is looking at an average.  The average is made up of winners and losers, long-term holders and short-term buyers/sellers, educated investors and uneducated investors, companies that perform well and those that fail, etc.  You need to be on the right side of these odds.  When someone buys a stock, someone else must think it is time to sell, and vice versa.  Who is correct? That means you need to understand what you are doing.  If you are working with a financial advisor, you need to understand what they are recommending and why.

Also remember that when you are looking at historical mutual fund performances, failed and discontinued mutual funds are dropped from the calculations.  Assume a company runs four Canadian equity mutual funds – two with returns of minus (-) 10% and two with positive (+) 10% returns.  The average is 0%.  However, if the first two funds are closed down, the company can thereafter report that their Canadian equity family of funds yields an average of 10%.  Be cautious when relying on such reporting.

Another example of biased reporting is by choice of time periods.  For example, the Toronto Stock Exchange composite index increased by 7.4% for the one year ended October 1, 2012.  However, if I back up just one month, you would see that the same index declined 6.2% for the one year ended September 1, 2012.  If I ware selling you stocks, which statistic would I show you?

You have choices of individual stocks, mutual funds, Exchange Traded Funds, pooled or managed investments, etc.  Each have their pros and cons, and your choice may depend on the amount of money you can invest.  I suggest you visit the Tax and Financial Planning tab of my web site.  There, you can read my article, “Finding the Right Investment Broker” and also visit my Useful Links for investing to learn more about types of investments and where to buy them.

c) Do you have the right personality?

Your investment personality is also important. If you are unable to accept the risk of stock market fluctuations, or if you would sell your investments immediately upon a general stock market decline, this strategy is not for you. I call this the “sleep factor”. If you will not be able to sleep because of stock market worries, you should not be in the stock market (leveraging or otherwise). You must be confident that your investment has long-term quality and will recover from such generalized market corrections.

e) And, then, there are many other “suitability” factors to consider

The Mutual Fund Dealers Association issued  Member Regulation Notice, MR-0069, on April 14, 2008 (updated on February 22, 2013) providing guidance to their members in determining suitable investments for their clients.  In Section 4 of the document, they discuss assessing suitability for leveraging strategies. This is recommended reading for you.  The MFDA suggests certain “red flags” that should prompt their members to revisit suitability guidelines.  They are clear that  leveraging needs to be considered on a case-by-case basis, and these red flags are only considerations in determining the appropriateness of such a strategy.  They suggest:

  • leveraging may not a strategy for clients with either no or low investment knowledge;
  • clients should have a medium or high risk tolerance; it is not for conservative investors;
  • it may not be appropriate for investors age 60 or over, or for those nearing or in retirement;
  • the investment time horizon should be long-term, being five years or longer (my personal preference is a minimum of 7 to 10 years);
  • the investment loan should neither exceed 30% of the investor’s net worth, nor 50% of their liquid net worth;
  • the total of all debt payments by the investor should be less than 35% of their gross income, excluding any income from the leveraged investment portfolio;
  • there should be no need to rely on the investment portfolio to meet loan payments (which I believe is important in case the portfolio stops paying or reduces distributions, as happened to some investors in the 2008 market crash).

A leveraging portfolio strategy may be appropriate even with one or more of these red flags present.  However, all of your circumstances need to be considered before moving forward as the existence of such issues increases your risk.  You should also receive a risk disclosure document as set out by the MFDA – Notice MSN-0074

d) Are you getting unbiased advice?

Many investors that I have met were introduced to the concept by their financial advisor or broker.  Borrowing to invest is often recommended by advisors who have something to gain by selling you more investments.  That is, they will receive more commissions and/or management fees from your additional investments, with all of the risk held by you.  They may also receive a commission or referral fee from the lender.

Sometimes, the risks are not well explained.  Therefore, it is my recommendation that you get a second opinion from someone independent, such as a fee-only financial planner or your accountant (as long as they are not accepting referral fees from your advisor!).   This may avoid you facing significant financial losses from an unscrupulous financial advisor who is putting their interest ahead of yours.  Read the case summary from the Mutual Fund Dealers Association of Canada (MFDA) web site regarding one of their enforcement actions to see what one financial planner did to his trusting clients.  Incidentally, even though the MFDA may penalize their members, this does not recover any money for the investors.  You are required to pursue a claim for losses on your own or through the legal process, if you can prove your advisor was at fault and you should not be held responsible for a valid reason.

I have a problem with certain investment advisors who use one particular leveraging strategy without fully explaining it. They recommend that you systematically withdraw money from your Registered Retirement Savings Plan (RRSP) or your Registered Retirement Income Fund (RRIF) as you near retirement or after you are in your early retirement years.  First, they advise you to borrow money and invest it.   This gives you a tax deduction for the interest.  For example, if you borrowed $100,000 at a 5% interest rate, you would buy $100,000 of investments and be able to deduct $5,000 of interest income expense. They then advise you to withdraw money from the RRSP or the RRIF equal to  the amount of interest,  being $5,000 in my example.  Therefore, your tax return shows income and expense of $5,000, resulting in no change to your taxes.  They demonstrate that this will make you more money in the long run by saving you taxes.  The demonstration normally compares the future growth on your existing RRSP alone to the growth on your declining RRSP plus the new leveraged investment.  Of course, the leveraged investment option assumes a positive return, so it will always be the better alternative because you have more money invested.

However, there is a third option which they do not show you.  This option leaves your existing RRSP/RRIF intact while still using the leveraging option.  This alternative will usually show the highest rate of return (unless your tax rate is going to increase significantly in retirement). Why? Because you continue to receive growth on your full RRSP plus you get a tax refund each year from your interest deduction that you can also invest.  If  this third alternative was shown to you, you would likely realize that the sales pitch has nothing to do with your RRSP/RRIF.  The RRSP (or RRIF) discussion is a distraction to peak your interest, as a ploy to sell you more investments.  If you receive this presentation, you should get a second opinion.     I agree that there are situations where money should be removed from an RRSP before retirement, before age 65, before age 72 or before  some other significant time, but  it is not likely that an investment loan will need to be part of the planning.

The Good Debt – Bad Debt Discussion

Advisors often talk about good and bad debt.  My personal belief is that there is  no such thing as good debt; there are “acceptable” debts and “bad” debts.  Just because you can claim a tax deduction does not make debt good.  Certainly, tax deductions are nice, but it is not the sole reason someone should spend money or take risks.

I believe acceptable debt includes your house mortgage, as long as the mortgage payments are within your budget, enabling you to purchase a home many years before you otherwise could afford to.  It may also include a car loan, especially if you need a car to get to work.  (As a side note, if you are looking at a 0% car loan, investigate further.  Negotiate the cost of your car based on a cash purchase, and notice how much the price of the car goes up when you tell the salesperson that you changed your mind and want to use their 0% financing offer.  You will then see the real cost of interest on your loan.)  Student loans are acceptable debt because of the future benefits you will receive through job security and higher pay.

Bad debts include credit card balances,  personal finance loans and lines of credit used to buy personal assets and pay for personal expenses before you can really afford them.

I do not think it takes rocket science to know that you should not start a leveraging strategy if you already have “bad” debt.  You cannot afford the risk of losing money if you are already unable to pay for your current bills.  Furthermore, if you have “acceptable” debt such a house mortgage,  it is my opinion that you would be wise to repay such loans before taking on additional liabilities.  However, this is an individual choice.  If you are prepared to take the risk of increasing your debt load if your investments are unsuccessful, you may wish to adopt a leveraging strategy.  The complainants that I met who were involved in the MFDA case to which I referred earlier were sorry they did so.

A leveraging strategy gives you the risk of losing money; no one can dispute this fact.  If you have loans already, and you lose money in the stock market, you will be further in debt.  This may very well jeopardize your financial future, including your ability to keep your home, your retirement planning, the education of your children and even your mental health as a result of the additional stress.  Consider the personal objectives and financial planning credentials of anyone who tells you different.  For the well being of your family, make sure both you and your “significant other” agree 100% on this important decision.

Summary

In summary, leveraging is only appropriate for a long-term investment strategy (7-10 years), using a high quality mix of investments with growth potential. You should have an emergency fund already in place, and have safe short-term securities available to meet all short-term needs for the next 7 to 10 years.  I think you should first have any insurance needs in place, no credit card debt or personal loans, appropriate contributions made to Registered Retirement Savings Plans, Registered Education Savings Plans, Tax Free Savings Plans, and, if applicable, Registered Disability Savings Plans.  I prefer to have your house mortgage paid off to ensure your family home is safe,  but opinions differ on this point.  Effectively, I am saying that you have your finances fully under control and your risk well managed.  You have no “need” for money.  Now, if you “want” more money, and are willing to take a chance of losing some of your existing wealth (regardless of how small the risk may be), talk to a professional financial advisor.  Let me emphasize that leveraging is for people who want more money but do not need more money, and can afford to lose some money and still be financially and mentally stable.

This is my opinion – there will be others with differing opinions, and I am always willing to listen and learn.

 

Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum