Borrowing to invest: Folly or fortune?
With volatile markets and Canadians’ aversion to debt, why is this Talbot Stevens guy still preaching borrowing for investment purposes (leveraging)?
Many financial advisors support conservative leveraging, while some clients don’t understand that it can be a smart idea or how to do it effectively.
Let’s face it, borrowing to invest has a bad rep. Conservative leveraging is viewed as conservative grizzly-bear wrestling – you’re going to get mauled.
Related article: The risks of leveraging
Stevens is at it again in his new book, The Smart Debt Coach: Secrets of the Rich to Increase Your Wealth and Security.
He makes a logical case in favor of borrowing to invest and distinguishes between good debt (such as for investing in assets that tend to rise in value) and bad debt (credit cards, cars). Bad debt destroys wealth, while Stevens says that good debt can create it.
Related article: The benefits to leveraging
Leveraging has been used successfully for generations by the wealthy. Stevens says that the rich aren’t afraid of debt and use it to increase their wealth by investing rather than to supplement their income and lifestyle as most of us do.
Stevens gives an example of someone who receives a $20,000 bonus. Let’s imagine that you use the money simply to pay down debt. The wealthy have a different mindset, which is how they became wealthy. They may use the money to pay down debt and then turn around and borrow it back. Invested outside of an RRSP or TFSA, the loan interest is generally tax-deductible. This debt-swap turns non-deductible debt into deductible debt.
Related article: Learn how to swap your debt
The author also recommends borrowing to invest in an RRSP, although this interest is not deductible. He gives an example of a person making a $3,000 RRSP contribution (roughly the average annual contribution). The contribution is made with after-tax dollars and a person may have to earn $4,500-$5,000 to contribute that $3,000.
Stevens suggests putting the before-tax amount into your RRSP. For example, if you’re in a 36-per-cent tax bracket (a common marginal bracket in my province of Alberta), gross up your contribution to $4,687.50 (borrowing if you have to) to save $1,687.50 in taxes, which can then be applied to the loan and you end up with a $3,000 debt and a $4,687.50 RRSP contribution and a larger tax saving.
Related article: The straight talk on RRSP loans
While market timing is generally discouraged, Stevens says that it can be a useful strategy when leveraging. “Again it goes back to the mindset of the wealthy,” he says. “They don’t borrow to buy when the market is high. They borrow to buy more businesses, competitors, real estate, stock market investments …when the market is down.”
Leveraging works when you invest in an asset that generally increases in price over time. However, it increases your potential for both profits and losses. For example, investing $10,000 of your own money and $10,000 of borrowed money doubles both your gains and losses.
If you leverage, do so conservatively and consider dollar-cost averaging to reduce your risk. You must make sure that your interest deduction isn’t tainted, so seek the advice of a financial advisor.
Related article: The power of dollar-cost averaging
Charting TSX market data back to 1957, the annual return is about 10%. Stevens points out that the market typically does very well after an off-year: an 18-per-cent annual return for an investment made after a year of negative TSX returns and a 25-per-cent return following a 12-month period when the market has been down at least 15%.
When borrowing to invest large amounts, he says, market timing “is critical. If you ever wanted to use your full (borrowing) capacity it should be one of those very rare times when the market is down, say, 50%.”
Borrowing to invest when markets have crashed and investors are most pessimistic requires courage, but that’s when your profit potential is the greatest.