Continuing from Part 1 where we discussed the basic concept of leveraging and why people can find it appealing, we continue with a few simple comparisons to explore the power of leveraging. These examples are similar to the ones provided by financial advisors – and you will see that they look very appealing. But remember, it won’t be until Part 3 of this series that I really go into detail about why leverages can be a really bad idea – so remember to continue reading the series before making any conclusions of your own.
A Simple Example
Let’s look at a simple 10 year scenario where we have made the following assumptions: Our investor has a marginal tax rate of 40%, he earns a rate of return of 9% on his investment portfolio and he has $1000/month to put away for his savings.
If he were to put $1000/month into his investment account (non-registered), his savings and growth on his savings would total $194,965.63 at the end of the 10 years.
If he were to take out a 10 year loan with loan payments of $1,000/month, then with an interest rate assumption of 7% for the loan, he could afford to take out a loan of $86,628.76 which he could put into his investment account. $86,628.76 invested for 10 years with a 9% rate of return equals $205,081.78.
If he were to take out an "interest-only" loan, or a line of credit and make only the minimum required interest payments – $1,000/month could buy you a loan principal of $171,428.57 (since $171,428.57 at 7% equals $12,000/year in interest costs). $171,428.57 invested for 10 years with a 9% rate of return would give you $405,833.77. BUT, don’t forget, our investor never made so much as a dent in the principal of the original loan, so we will have to subtract that from the investment balance at the end of the 10 years. $405,833.77 less the $171,428.57 loan balance leaves us with $234,405.00.
So to Recap:
Monthly Savings = $194,965.63
10 Year Term Loan = $205,081.78
Interest Only Loan = $234,405.00
Interest Deductibility of Leveraged Investments
There is one more important piece of information that we need to look at – and that is the interest deductibility of leveraged investments. If you are familiar with our tax system, and specifically for the area of business, you will know that if you take out a small business loan so that you can start or operate a business, then the interest that you pay on this loan is a "cost of doing business" – treated similarly to money spent on acquiring raw materials, spent on advertising etc. Costs of doing business are deducted from the company’s income before being subject to tax. In other words, a company’s NET INCOME is basically summed up by looking at their GROSS INCOME (from sales) and then deducting the costs of doing business – so again, the company does not pay tax on money used in order to carry on its business. Generally speaking, interest on a loan is tax deductible if the loan’s proceeds are put towards endeavours that have a reasonable expectation of profit.
If you borrow to invest – either in a small business or in stock and bond market investments, you have a reasonable expectation of profit – and as such, you may be allowed to deduct the interest on your loan. I say "may" since technically, you should have this verified by your own accountant for your specific situation first – BUT, I have yet to hear of someone who has not been able to do so as long as they keep a proper paper trail that shows that the money borrowed was used exclusively for investing and nothing else.
(If you add other expenses to your Line of Credit – like home renovations or vacations, etc. – then you could potentially lose the ability to write off the interest on your leveraged investment! So remember to keep a GOOD paper trail and not to co-mingle funds.)
If we were to figure that our investor could write off the interest payments on the loan, then to maintain an out of pocket cash commitment of $12,000 to his investment strategy per year, he could actually support a monthly interest payment of $1,666.66.
12 interest payments of $1,666.66/month equals a yearly total of $19,999.92. If we take that amount and multiply it by his marginal tax rate of 40%, we get a tax refund of $7,999.97. $19,999.92 less the tax refund of $7,999.97 yields $11,999.95 – or in other words almost exactly $1,000/month.
So now we would figure out how much of a loan $19,999.92 would support (interest only) and we come up with $285,713.14, which if invested for 10 years with a 9% rate of return would give our investor a gross total of $676,386.92. Again, we have to subtract the loan balance (which never gets paid down during the 10 years) and we are left with $390,673.78.
Let’s Recap the Monthly Savings versus the Leverage Again:
In both scenarios, our investor is spending $12,000/year (or $1,000/month) out of pocket:
Monthly Savings = $194,965.63
Interest Only Loan = $390,673.78
Remember, this post was designed to show the upside potential of a leveraged investment – so don’t go out and get a line of credit and just start implementing this strategy. We haven’t looked at real-life scenarios as we have just assumed static rates of return and interest – if you could earn 9% per year, EVERY YEAR, of course this would make a lot of sense – but like we all know, theory and practice are two different things.
Just think, what if you averaged a rate of return that was less than the average rate of interest you paid on the loan? What if your investment lost money over 10 years? You would still have the original loan balance to pay, and your investments would not be able to cover this amount – you could have shelled out $1,000 month for 10 years and still owe another $100,000! Oh yes, a leverage can "blow you up real good!"
Part 3 will look at the major problems that ruin most real-life leverage strategies.
Part 4 will introduce a solution that I think addresses many of these problems.
As always, leverage magnifies potential returns and risk. Getting a fixed rate loan introduces more risk and return potential, and going with an interest only credit facility introduces a WHOLE LOT MORE risk and return potential – BE CAREFUL!
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