Just recently, I have heard from a number of readers who have been pitched to borrow money to invest. One recent pitch went something like this:
Your house has appreciated a lot in value in the past 5 years. Most financial institutions will lend you up to 75% of the value of your home. Today, you have a home worth $400,000 which means that you borrow up to $300,000 against the value of your home. Your mortgage is only $150,000 so why don’t you take out a $100,000 line of credit at 6% and invest in a secure mortgage paying you 12%. Not only is the interest on the loan tax deductible if you use it for investment purposes, but you can also use the extra return to pay down your $150,000 non-deductible mortgage even faster. You can’t go wrong. All you have to do is start with a credit application.
Personally, I am not against the concept of borrowing to invest. However, I think leverage as we call it, is over promoted and oversold. Before you decide to borrow money to invest, remember three things.
- Investment returns – if it is too good to be true, it probably is. Investment returns have been pretty solid for the past 4 years. Whether it is mutual funds, stocks, mortgage investments or real estate, it is easy to be lured into leverage with examples using good returns. But what if the investments do not perform? Are you able to cope with margin calls, lack of liquidity and most importantly the emotions of an asset that is worth less than the debt you owe? When running projections, make sure you use many different returns including scenarios where you lose money. Today, the risk free rate of return is about 3%. Any returns higher than that have some additional risk. It’s the laws of investing. Make sure you are aware of those risks.
- Tax deductibility – do you really understand the rules? A lot of focus is often placed on the deductibility of the interest. However, the government (CRA) has some very strict rules about what investments qualify for deductibility of interest. Make sure you understand those rules in detail. In addition, the government is currently reviewing the interest deductibility issue so ask yourself, what happens if the rules change?
- Do you understand the risks of leverage? Most proposals I have seen make leverage look great. Who wouldn’t sign on the dotted line if you could borrow at 6% to get a return of 12%. The reality, however, is not everyone makes money on leverage. In fact, I’ve seen many people lose money and the problem with losing money in leverage is you are losing money you don’t have. Don’t just look at the benefits of leverage. Make sure you consider the not so good scenarios or even better, the worst-case scenario. In the example above, what would happen if interest rates went up and the cost to borrow was 8% or 9%? What if the investment stopped paying interest and you had to cover the interest on the debt out of your cash flow? What if the housing market started to tank and you house was worth $300,000 instead of $400,000? What if the 12% investment was a scam, how long would it take to pay off another $100,000 of debt? What if an emergency came up and you just needed some money? Could you sell out of the investment?
As I said in an article earlier this year, its time to change the way we think about debt. Instead of going into more debt, we should start focusing on paying down our debts. When it comes to leverage, I believe in one simple thing; Make sure you are educated and not sold.