Leveraging Comes In Different Forms
Leveraging is getting a lot more attention these days. In the last couple of weeks, we spent some time talking about the benefits and risks of leveraging. If you are looking to put some leveraging strategies in place, I will share with you some of the different forms of leveraging.
- Buying Real Estate – This is the most common form of leveraging. The difference between the purchase price and your down payment is the leveraged amount. For example, if you buy a property worth $100,000 and you put down $25,000, then you are leveraging $75,000. In real estate, you can put down as low as 5%. However, if you invest less than 25%, you will face a CMHC fee. In most circumstances the financial institution will require that the property be used as collateral on the loan. From a tax perspective, it is important to note that if you are buying your personal residence, the interest on the loan is not tax deductible.
- Leveraging paid off homes – In some places, real estate can be a great investment. However, in other places, real estate has appreciated at modest rates. If you feel real estate has a modest future, you might consider using the equity in your home more productively. For example, if my home is worth $200,000 and it is paid off, I can generally get a line of credit for about 75% of the value of the home. If I think the markets will appreciate at a faster rate than my home, I might choose to get that line of credit, borrow the money and invest it into mutual funds.
- Matching programs – Matching programs work like this. Say you have $10,000 to invest. What you can do is get a financial institution to match your investment with borrowed funds. A 2 to 1 matching program means the financial institution will lend you $20,000 on your $10,000. A 3 to 1 program means you will get $30,000 of borrowed funds for $10,000. One of the major concerns over matching programs is the dreaded margin call. If the investment drops in value to a point below the borrowed amount, the institution can call the loan. There are some institutions that have programs now where there is no margin call.
- Borrow off lines of credit – Any line of credit can be used for investment purposes. One of the most important tips I can give you is to make sure that you can track the use of the funds for interest write-off purposes. In fact, you are better off getting 2 separate lines of credit – one for investment purposes and one for personal purposes. For tax purposes, it is your responsibility to prove that the borrowed money was used for investment purposes.
- Replace mortgage with leverage – Sometimes I run across individuals with a mortgage and also investments outside the RRSP. For these people conversion of debt from non-deductible to deductible makes a lot of sense. For example, let’s say you have a $50,000 mortgage and you also have $50,000 in mutual funds. If we ignore tax and fees, lets assume you sell your $50,000 in mutual funds so that you can pay off the mortgage. Now, you have a clear title home. What you then do is go to the bank and get a $50,000 line of credit secured by the home and borrow the $50,000 to re-invest into mutual funds. In the end you are in the exact same situation as you were at the start. The difference is you have more flexibility on the repayments and more importantly, the interest on the $50,000 is now tax deductible.
- RRIF meltdown – I often get the question “Is there a way to get the money out of the RRSP without paying the tax?” The RRIF meltdown is one possible strategy. For example, say you are 69 and you must start taking income out of your RRSP. Let’s say you have a $100,000 in a RRIF and for simplicity sake you must withdrawal $4500 in income. To avoid paying the tax, you must create an offsetting deduction of $4500. To do this, you can borrow $65,000 and invest it into mutual funds. The interest on the loan at 7% is $4500. This interest is tax deductible if you borrow to invest the funds.
Leveraging can be very complicated because there are so many variables involved. The descriptions here are oversimplified due to space constraints. Before you decide to leverage, you should consult with a financial professional like an advisor and/or and accountant to see if it makes sense for you.