Borrowing From Peter To Invest In Paul- Part 2 Leveraged Investing Options And Strategies

Colin Ritchie Since I first penned Part 1 to this series, I have had the chance to chat with several advisors who regularly use this strategy for the right clients, including Hal McInerney of WMS Financial in Vancouver. Hal shared a January 26, 2012 article from Tim Cestnick originally published in the Globe and Mail entitled Does Leveraged Investing Really Work that compared investing $5,000 in an RRSP, a TFSA or via a leveraged investing strategy.

Hal also shared an article written by Ayres and Barry Nalebuff, a couple of Yale University professors firmly in the leveraging camp. A quick search of the internet found many articles written by them on this subject, including those published in Forbes Magazine and Time. They take the position that leveraged investing when you’re young is a good thing and less risky than not leveraging.

I’ve also chatted with a few, such as Richard Vetter of Steveston, British Columbia, that are not fans of the idea. Among things, Richard dislikes both the extra risks, go along with using someone else’s money to put into the market and the psychological toll leveraged investing can take on investors, which can both interfere with their quality of life along the way while also prompting them to unwind the strategy at exactly the wrong time.

Ultimately, to my way of thinking it comes down to who, when, how and how much. In other words, I focus on:

the personality and experience of the investor;

their time horizon and financial situation;

their investment choices and related fees; and

how much of other people’s money they’re putting into the game, funding strategy and borrowing costs;

I leave it to you to draw your own conclusions. If you decide that this is the thing for you, the rest of this article is devoted to ways of increasing your chances of success so that you can both sleep a little bit better along the way and hopefully have a larger nest egg to spend when you get to where you’re wanting to go.

Investment Strategies

The key variables when you’re looking at options are: whether you want to borrow a little bit at a time or all at once, and when you plan on investing and unwinding this strategy. Borrowing in a single fell swoop is definitely simpler in a variety of ways. First, it allows you to construct a diversified portfolio and gives you far more investment products from which to choose. Since some investments require a minimum contribution to get started, or are impractical, those of you without the desire or cash flow to invest in large chunks will probably look to products like mutual funds and segregated funds rather than individual stocks and bonds, at least until you’ve accumulated a critical mass. Of course, funds offer their own advantages as well, so this lack of choices might not be a drawback in your situation anyway.

To my mind, the greatest risks to investing all at once are market timing and perhaps taking on too much risk too soon. To the first point, investing with borrowed money already bumps up your risk level significantly. Accordingly, I suggest being extra cautious regarding when and how you invest. Rather than hoping you’ve picked the single best day to invest over the last decade, why not stagger your entry into the market over a number of months or years? Even if you now have the ability to borrow $100,000 against your home, this doesn’t necessarily mean that you should do so, or do so all at once. Although you might not make as much money as you would if you really could determine the best single day in history to invest, you are at least protecting against the possibility that you might have picked the worst possible day instead. Although slowly putting in the $100,000 in chunks of $10,000 at regular intervals may not match your enthusiasm or personality, I believe that protecting against losing borrowed money is worth forgoing some of the potential upside.

Furthermore, although you may think you’re okay with leveraged investing, if you discover you don’t like the stress, it is a lot easier to unwind your holdings with minimal damage if you’ve only dipped your toes in the water instead of going “all in” (e.g., after your portfolio has gone off by 15%).

I also worry about when people choose leveraged investing, both in terms of whether it is too soon in their financial life or too late (e.g., for older investors who simply can’t afford to lose money). By the same token, there may come a time to either reduce leveraging or sell off completely, such as when you’ve already hit your financial goals, or when you’ve hit retirement with a limited cash flow and a continuing mortgage.

Returning to the basics of funding strategies, if you can’t afford large lump-sum payments or smaller, sizable contributions over a set period to fund your investment portfolio, then something like the Smith Manoeuvre might be up your alley. I won’t elaborate here, as there is lots of information available about this on the web or you can even buy his book. More currently, Gordon P. Johnson’s recent book entitled Turn Your Mortgage into a Pension offers his ideas on generating cash flow using your home equity. In 1,000 words or less, both authors use the following basic idea: when you make a mortgage payment, part of it is interest and part is principal. After each payment, you can turn around and borrow that part of the payment back and invest in the market. This is where a separate HLOC or readvanceable mortgage comes. Now, with any luck, you are invested in something that not only covers the interest portion of the new 100% deductible investment loan but also will either generate a lot more income along the way or hold out the promise of significant capital gains down the road.

With each mortgage payment, the process continues until, theoretically, you’ve paid down your original mortgage but now own an investment portfolio that, if things have gone well, is worth far more than what you owe; you will also have an investment loan. If your investments generate very significant cash flow or you sell some of them off along the way, you can use this extra cash toward your mortgage to speed up that happy day when your mortgage is completely tax-deductible. If your goal is to retire debt-free, you can then start directing the money formerly allocated to your mortgage toward your investment loan, or sell off all or some of your holdings to settle the score (or some of both.)

Gordon Johnson’s premise is slightly different. He focuses on investments that generate cash flow in excess of interest charges, and that react similarly to the interest rates on your investment loans when the rates change. In fact, he argues that his strategy isn’t leveraging in the first place but a savings plan, as the investors’ total debt never increases and they are really borrowing back their own money. Although I will let his book speak for itself, one of the investments he recommends is a Mortgage Investment Corporation (MIC). Investors invest in pooled mortgages that (in Canada at least) have paid out well in excess of carrying charges for a prolonged period. Essentially, he describes it as doing what the banks do: borrowing money at a lower rate than you can earn when you lend this same money to someone else.

Accordingly, he is not particularly concerned about the amount of debt someone takes into retirement, in light of the extra cash flow the portfolio generates. In fact, he suggests that some of us may be better off carrying debt in perpetuity rather than having to liquidate high-yield investments to pay down deductible low-interest debt.

Of course, your decision doesn’t have to be one or the other; even if you do decide to take some of your investment debt with you into retirement, you always have the option of hedging your bets by paying down part of the loan and letting the other part ride.

Tax Stuff

To begin, if you want to write off your interest, you have to have a paper trail showing that the money was borrowed to earn investment or business income. I have highlighted “income,” as investing to produce only capital gains doesn’t count. For example, you wouldn’t be eligible for an immediate write-off if you bought empty land with a purpose of flipping it “as is” in a few years, but you would be able to write off a stock that paid a small dividend. In fact, the CRA has allowed investors to write off interest used to buy investments that currently don’t produce income if it can be argued that they might in the future. If in doubt, talk to your accountant.

As discussed earlier, if a loan is for a blend of deductible and non-deductible debt, you can deduct the percentage of loan interest you’ve paid equal to the percentage of the loan that was deductible in the first place.

This ratio wouldn’t change going forward unless you borrow more money in the same account (which probably isn’t a good idea). Generally, you are better off having separate loans for deductible and non-deductible debt so you can focus on paying down the non-deductible debt sooner (assuming rates are comparable). Continuing the interest discussion, I want to provide a final reminder that only interest income actually paid can be deducted. In other words, you can’t claim a deduction for an expense you’ve never paid.

Finally, when picking suitable investments — and, if investing as a couple, determining whether it makes more sense for just one of you to implement this strategy — it is also important to remember how these investments will be taxed. Unless you invest in something that also produces 100% income or interest, each dollar of investment income will be taxed at a lower rate than the rate used to calculate your interest deduction.

In other words, while 100% of interest income is taxable, only 50% of capital gains get taxed. If earning dividends, the dividend tax credit ultimately means you pay a lot less tax per dollar of dividend income than you deduct per dollar of interest. Even better, some investments also pay out some or all of their money each year as a tax-free return of capital, which can really tip the results in your favour.

By way of example, if Rich paid 3% interest to earn 3% in dividends, has a taxable income of $60,000 per year and lives on the Sunshine Coast, he can deduct 29.7% of his interest but gets taxed only 6.46% on the dividends. In other words, although at first glance it looks like his investment income and expenses cancel each other out, he’s still ahead of the game by about 0.7%. Over time, due to the magic of compounding, these little differences can eventually amount to big savings, especially when larger numbers are involved.

When deciding whether it makes sense for both or just one spouse to lever up depends on their respective income brackets, what types of investments they expect to own, and the distribution of assets between them, among other things. In the end, it really depends on each situation. Generally, if investing in something designed to produce mostly taxable income — such as an MIC — then they are probably better off investing through the lower-income earner in order to take advantage of his or her lower tax rates, even though that person would get a lower deduction on the interest charges.

Conversely, if investing in something that produces deferred capital gains or return of capital, they are probably better off having the higher-income earner enter the market in order to maximize deductions, especially if the plan is for him or her to sell off after retirement when in a lower tax bracket. Again, a lot depends on the circumstances, so either do your own research or get expert advice before figuring out what makes the most sense for you.

Investment Choices

As underscored by the comments in the last two paragraphs, it isn’t so much about how much an investment earns, but how much you are able to keep after deducting your interest charges and paying your taxes. Accordingly, when deciding if and how to invest, you may need to keep your calculator and tax-rate table handy.

Leveraged investing can also be about managing cash flow. Taking on investment loans can mean increasing how much you need to pay toward your total debt each year. If that applies to you and you’re already struggling to pay your bills and do the extras (such as fund your RRSPs and RESPs), then you will probably need investments that pay you as you go — and pay reasonably well. Not only can the investment income at least cover your increased borrowing expenses, perhaps it can also allow you to actually top up your RRSP this year and thus leverage your tax savings.

Finally, and in my view most important: since investing with other people’s money is a risky venture, it is important to take less investment risk than when investing your own cash for the long-term. To borrow from the Hippocratic Oath, I believe the first principle of investing with bank money should be “do no harm” or, at least, “minimize the chances of things blowing up entirely in your face.” I suggest picking investments designed to produce a reliable, stable and secure cash flow each month or quarter, and one that exceeds your carrying charges. If nothing else, even if your investments don’t grow in value, I would want to do what I could to ensure my investments pay for themselves along the way and, at worst, more or less break even over the long term.

Along those lines, I suggest looking at investments like MICs, preferred shares with fixed redemption periods, convertible debentures, high quality bonds (rather than a bond fund) and income funds as the backbone of your leveraged investment portfolio. All of these products are designed to produce income and are less volatile than equities. I also suggest diversifying rather than just using a single investment vehicle such as an MIC. If you want to take more risk, consider doing so only with investment gains, such that, in the event that those investments don’t work out, you’re losing your own money rather than the bank’s. Even so, if you want to up your risk threshold after establishing your base, consider doing so only modestly, and continue to choose investments that pay their own borrowing costs along the way.

If investing in funds, I would suggest investigating corporate class mutual funds (again, preferably income funds) for their tax efficiency; however, although tax savings are nice, it is more important to focus on investment returns. That is, if your investment is likely to lose money anyway, or substantially underperform its peers, then tax savings probably won’t be much of an issue anyway.

Conclusion

There is a lot more I could say about leveraged investing, but once again I am running out of space and time. In the end, no matter how you sugar coat it, leveraged investing using your home equity is taking a big risk (although you can take steps to mitigate that risk); whether it’s something you wish to undertake is up to you. If things work out in your favour, it can definitely be a game changer, but, if you’re ahead of the game in the first place, then perhaps a game changer is not what you need.

If this is something you’re interested in exploring further, here are a few tips I hope will cause you to name a child or household plant in my honour ten to fifteen years down the road:

Be aware of interest-rate risk. Look at locking in part of your borrowing costs at some point, particularly when your total debt load remains uncomfortably high.

Leveraged investing doesn’t have to be an all-or-nothing thing. Consider borrowing back only part of your principal payments rather than every last dollar. If you are a first-time homebuyer, I suggest waiting for at least three or four years in most cases before even considering getting started.

Focus on income, safety and reliability as opposed to shooting for the moon. Pigs get fat; hogs get slaughtered.

Get the advice of an independent mortgage broker. Picking the best borrowing product and terms can be as important as picking the right investments. Make sure you know the terms: when loans can be called in, prepayment privileges, monthly fees, and the ability to automatically borrow against the new equity you create in your home after each principal payment.

Diversify your investments; focus on earning at least enough to pay your borrowing costs, and play it extra safe when investing exclusively with the bank’s money.

Crunch the numbers in advance. Get an idea of your true cost of borrowing and the true rate of return on your proposed investments to get a better idea of your cash flow after the tax man has come and gone. Likewise, as the aforementioned Richard Vetter, reminded me, look at the fees you’re paying and previous returns net of fees, as high fees can turn potential good investments into bad ideas.

Keep your total debt levels under control, and consider fully or partially deleveraging at retirement. Again, if you’re already on track to hit your goals, why risk things going sideways for a few extra dollars you don’t really need; and,

Sometimes the best answer is to just say, “no.” Leveraged investing is not for the faint of heart and it is always possible that it could blow up in your face, no matter how compelling the math. Perhaps you’re better off looking at other ways to fund your retirement.

As always, I welcome any comments or suggestions. Until next time, may interest rates stay low and your investment returns reach stratospheric heights.

Colin S. Ritchie, LL.B., CFP, CLU and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com