Through the last half of the 1990's you could not turn your head without hearing some financial guru or expert spurting the benefits of leveraging. To put it in simplest terms, leveraging is simply using someone else's money to make money.
Most of us have leveraged in our lifetime, for example buying a house. You can put down 5%, 10%, 25% and the bank lends the rest of the value of the house to you. It is your responsibility to pay back the loan in the form of a mortgage.
In the investment business, leveraging is where you borrow money to invest. You can use a line of credit or there are more formal leveraging programs where financial institutions will match your investment in some relationship. This concept has a key benefit where the interest on the loan is tax deductible. Often these investment loans are much more flexible than a mortgage because you do not have to pay down principle from month to month. You can typically arrange to only pay the interest, which has significant benefits from a cashflow perspective.
The key to making money through leveraging is that your after tax return on the investment must exceed the after tax cost of the interest.
Now may be the time to leverage
I know this may be a tough sell when markets are at significant lows and your investment portfolio is looking anything but exciting. However, history has shown that markets will come back and they will exceed previous highs. This I know to be true. The problem is I cannot tell you when this will happen and how long markets will take to recover. My bet is it will happen sooner than you think.
You see investor psychology comes back to play here. When markets are down, emotion and psychology convinces us that markets will keep going down (just like now). When markets were up, the opposite was true.
If you think with the head and not the heart, you may find that logically, markets are low and buying low means you should make money in the future.
I would like to share with you some of the reasons why thinking with the head instead of the heart may lead you to the conclusion that today may be one of the best times to leverage.
- In order to boost the economy and prevent recession, the governments are dedicated to a monetary policy of lower interest rates. Lower interest rates means that your interest costs are lower in a leveraging program. Remember the key to making money through leveraging is that your after tax return on the investment must exceed the after tax cost of the interest.
- Lower capital gains inclusion. The other part of the equation is you want higher after tax returns. With the changes to lower capital gains inclusion to 50%, it is in your interest to earn higher after tax returns.
- Investing today means you are buying low. If you were the investor back in 1997, 1998 or earlier and you had visions of the TSE breaking 12,000, remember that will still happen. And today, you can invest into the markets where pretty much everything is on sale.
The last thing I want to happen is to have you run out and leverage your investments. You must consider these thoughts with caution. Leveraging has risk and you must understand those risks. I offer you some final thoughts on when leveraging makes the most sense:
- Firstly, you should have a stable flow of personal income. You must be able to handle the interest or loan repayments. Make sure you build in a comfort zone just in case interest rates go up and therefore, your payments go up as well.
- It makes little sense to leverage to buy GICs or other conservative investments. As a result, you must have a comfort for investment volatility. In the short term market movements are random. If you are a nervous investor, leveraging not only magnifies the ups but also the downs.
- To get the tax benefits of tax preferred investment income like dividends and capital gains, you will need to be comfortable investing in mutual funds or other equity investments.
- It is import to have a financial situation where the deductibility of interest makes sense. The higher your marginal tax rate, the more benefit you might derive from leveraging. However, keep in mind that a higher marginal tax rate also means that you will pay tax on the investment at a higher rate too.
On a personal note, I am feeling pretty good about the markets and I will be putting my money where my mouth is and leveraging into the markets. Just because I do it does not mean you should too. Use leverage with caution and respect.