One of the most popular investment strategies over the past 10-year has been leveraging. Leveraging comes in many different forms but the basic root of the concept is investing money with borrowed money. I get lots of questions from readers about this popular idea. Here's an example of a scenario that comes up quite often.
Julie and Sam are young newlyweds who are eager to get their finances in shape. Their first goal was to buy a home and they got into the hot Alberta market a few of years ago, which proved to be a good move. Because they stretched themselves in the first place to buy their house, they have little savings. At the same time however, because of the boom, they now have bonus equity in their home.
Julie and Sam went to see a financial advisor to get help building a portfolio. Their financial advisor suggested that they use some of the equity in their house and get it out so that the money can start working for them. More specifically, the advisor suggested they had ample equity in their home to set up a line of credit for $25,000 for investment purposes. The interest on the loan would be tax deductible and a good conservative equity mutual fund should be able to outperform the cost of the loan.
Julie and Sam asked me what my thoughts were on borrowing to invest. Here's my two cents for what it is worth.
- Home equity has been your best investment. Julie and Sam's home is an investment just like a portfolio of mutual funds is an investment. In fact, their home has been their best investment. It's hard to understand why they have to get money out of their home to get it invested when their house is an investment on it's own. Although one might argue it is not as diversified as a portfolio of stocks, it's still invested in an appreciable asset.
- Make sure you understand both sides of the leverage. There's no question leverage has the potential to make money. Clearly if markets go up and interest rates stay low, leveraging works well. However, markets don't always go up and interest rates could climb (like they have in the past year). If someone pitches leverage to you make sure both the rewards and the risks are presented. Unfortunately I've seen far too many cases where leverage did not result in the best-case scenario.
- Leverage creates an emotional rollercoaster. Leveraging is not a new concept. Investing with or without leverage has its ups and downs. What is important to know is leveraging magnifies the emotional rollercoaster. You will love the ups way more but the downturns can be incredibly painful. Are you in a position, emotionally and financially to weather through these ups and downs?
- People need to pay down their debts instead of going into more debt. I know I harp on this issue a lot but as far as I am concerned Canadian have too much debt. Paying off debt can be one of the best investments you make. Think about this. Let's say your mortgage interest rate is 6%. If you pay that down, it is like earning 8% on a GIC on a pre-tax basis. In order to get the same return through leverage, the investment before the interest cost needs to earn 11% to 13% on the investment. That makes paying down debt look like a pretty good investment.
Don't get me wrong; I am not trying to be completely negative about leverage. I think leverage can be very powerful and a good investment strategy for the right people and in fact, I've done some leverage myself in the past. I just think it is important before you borrow to invest that you look at the good, bad and the ugly before you borrow money to invest.
For Julie and Sam, I think rather than go into more debt, they might be better off starting an automatic savings plan with the cashflow they would have used to pay the interest on the loan.