HomeAn article about using leverage for wealth accumulation
Everyone wants to do a little better, or get ahead a little faster. Borrowing to invest, if arranged properly is often a very attractive method of helping a client to reach their financial planning goals. The trick is in showing them how to take the risk without over exposing themselves to loss. There are many ways to minimize the portfolio risk and the leverage risk while still achieving the client's goal. This article hopes to explain some of the options available. Leverage investing is not for every client but an awareness of its potential and the safeguards available, need to be considered so as to make it available to those that might not otherwise consider it.
Most of the very wealthy people throughout history have gotten there by borrowing to invest. Whether it was to start a business, or an enterprise, or to make an investment, it is only by taking some risk that they were able to succeed. For most people buying a home is the largest single investment and it is most often also their biggest debt. Many homeowners would be surprised if you told them their home was a highly leveraged and high-risk investment. In fact, it also lacks the basic safeguards of diversification, liquidity and debt servicing options. I am not suggesting that home ownership is a bad thing, only that it needs to be kept in perspective.
For many people that come to see a financial advisor their goals cannot be attained without some drastic changes to their lifestyle, such as investing a portion of their income. Or, new tactics for portfolio growth such as borrowing to invest. Most clients will tell you they are opposed to any risk, while in the same breath stating that they want above average returns similar to those experienced for a time in bull markets. Rather than adding portfolio risk, a conservative investment programme can be established with leverage that carries some safeguards such as protection against loan call demands. Investing with leverage allows them the potential to produce far more wealth than is possible without taking advantage of other people's money and the tax laws.
Now Is Better Than Ever In the past, equities have as you know outperformed other types of investment over the long haul. The trouble was though that the cost of money made it an iffy proposition even with the tax deductibility of the loan servicing cost. Today we have a situation where the borrowing costs are lower than most people can remember. Coupled with this, is a stock market that is showing the signs of a recession. Many argue that we are now at the bottom of the market-cycle, others argue that the markets are near the bottom. Market timers have horrible track records. It is like trying to catch a falling knife. No one can predict with any accuracy that we are at the bottom of the market cycle. Most however, would agree that we are near the bottom. Either way now is the best time to get invested. With five-year mortgage rates now under six percent, the after tax cost of the loan can be in the area of three to four percent, depending on the clients tax bracket. Finding an investment that will yield more than that with a minimum of risk becomes a no-brainer exercise. The long-term after tax yield of course needs to be greater than the net cost of borrowing.
Added to this unique period of opportunity is the fact that the inclusion rate for capital gains has been reduced to only fifty percent of the capital gain as being taxable for a Canadian taxpayer. This of course makes the eventual realization of the gain much less painful, especially if it can be realized in a lower tax bracket than currently exists such as in the clients' retirement. There is also the added advantage of compounding the growth and a deferral of the tax liability well into the future. This is using the government's money to invest and make the funds grow so as to be able to settle the tax liability in the future with appreciated funds. Tax incentives such as interest deductibility on borrowed money and now a low capital gains inclusion rate are the governments way of encouraging investment to stimulate the economy. So drape a flag around yourself and do it for your country.
Equity Take-Out Mortgages Our favourite method of borrowing for investment is with an equity take-out mortgage. Although there are simpler ways of securing funds such as margin loans, lines of credit, demand loans, or 2 for 1 programs, etc. None offer the same security as the mortgage. A demand loan as the name implies can and will be demanded for repayment with little notice when the value of the underlying securities drops below a predetermined percentage. The fact that there might be a 3 or 5-year re-payment schedule does not imply that the loan cannot be recalled. It can also be demanded if the banks loan portfolio is in trouble at your local branch, or there has been a change of managers who looks at things differently. Advisors who have been in the business for a length of time have had the experience of trying to help their clients recover from all of these activities. The problem of margin calls and other loan calls applies to almost all of these other credit arrangements. If the loan was used to purchase a portfolio of mutual funds, a margin call with 24 hours or less to settle, would be almost impossible to settle on time, due to the required turnaround time. One financial institution released information that in the first three months of last year there were 19,000 margin calls on 95,000 margin loans. The beauty of the mortgage is that it has nothing to do with the portfolio as it is secured only by the underlying real estate.
Many clients have a considerable equity in their homes and need to realize that their home will continue to go up in value regardless of the mortgage, or its amount. If they have non-deductible debt it is usually better to re-finance first to pay out the non-deductible debt and then latter look at separate financing for the purpose of leverage investing. The client needs to understand that the collateral used for the loan is not the criterion that determines the deductibility of the interest expense. The collateral used for the loan is immaterial to the interest deductibility. It is the use of the borrowed funds, which determines the interest deductibility. With that in mind, any of the client's assets are available as collateral and can be used to negotiate the loan package that offers the strongest safeguards for the client.
It is important that the financing for leverage investing be separated from other non-deductible debt the clients may have. Often clients that have undertaken this on their own have commingled the financing, which later makes it impossible to know how to apportion the payment if they make an extra loan payment. At the very least allocating the interest expense at year-end becomes a headache. It puts at risk the deductibility of the loan interest. It solidifies the old rule that 'the person who is their own advisor has a fool for a client.'
Probably the two biggest advantages of an equity take out mortgage are firstly that it cannot be recalled and secondly is the certainty of the loan servicing cost for a predetermined period. By avoiding the risk of a margin call, or loan demand the long-term investment portfolio can be left in place to do what it does with faith in the long term. We like to use equity mutual funds for these programs so the manager can do what he is supposed to do at a downturn in the markets. That is taking advantage of their accumulated cash to buy currently undervalued companies. A demand loan can change interest rates every month, or more often. In a period of rising interest rates it could cause the client to abandon the program prematurely and suffer losses, exit fees or commissions. With a mortgage, a fixed rate for servicing the loan can be obtained for at least five years, or more. This provides security in being able to ride out a rising interest rate market. We like to set these plans up with a long amortization period to minimize the debt-servicing obligation and maximize the interest expense tax deduction. But, at the same time negotiating a 20% per year additional principal repayment option. In this way the client has maximum flexibility to reduce the mortgage if need be prior to renewal if an increased renewal interest rate is anticipated. Accelerated payments, or weekly payment options are also available as an additional safety measure. Ideally it would be better if the client applied any extra payment to the non-deductible mortgage, or other debts first.
Although a mortgage often carries an appraisal fee, or other application fees, these are negotiable often to nothing to get the clients business. If paid they are also tax deductible in the year they are incurred, giving the client a little extra tax refund in the first year.
When the cost of servicing the debt for investment purposes is known, arrangements can be made to service the debt either from the clients disposable income, or the newly created disposable income as a result of debt restructuring, or from the income of the investment portfolio itself.
Using The Portfolio To Service The Loan The ultimate play on using 'Other Peoples Money' is to use the income from the leverage portfolio to service the loan. Investment funds are of course ideally suited to providing the income stream required for meeting the debt-servicing obligation. Withdrawals from the portfolio can be automated to arrive at the client's bank a few days in advance of the loan payment charge against the client's bank account. This can usually be done without triggering any withdrawal fees.
There are a couple of important factors to keep in mind. In order for an investment loan to be tax deductible the portfolio must produce income from a business or a property. That is why, for example, a loan to acquire raw-land is not deductible. Because there is no likelihood of income and therefore the interest cost must be added to the cost base of the property. It is therefore in effect not deductible until the land is sold. The other factor is to see that the income withdrawn from the portfolio is not excessive to the point of eroding the adjusted cost base (ACB) of the portfolio too far below the amount of the loan. If the cost base of the portfolio was substantially below the remaining principal of the loan it could bring the interest deductibility into question. While highly unlikely to cause any more than a pro rata distribution of the expense it does need to be considered and the client made aware of any potential risk to the loans deductibility.
By applying the tax refund to the loan the possibility of drawing the cost base of the portfolio below the balance of the loan is not very likely. By securing the loan with a mortgage, an amount of principal is being paid every month, which should also avoid the cost base being drawn down below the remaining loan amount. In any event, in an average year the dividend distributions that are reinvested will increase the cost base by an amount close to the amount of the withdrawals if they have been kept to a reasonable amount. A good record of the ACB for each investment in the leveraged portfolio is a necessity. A good audit trail could save a lot of grief in the future. For another article on the subject of using the portfolio to service the loan. Click Here:
Choosing good solid long-term investments for the portfolio is often the easiest part. We like to use mutual, or segregated funds. We usually select conservative growth type equity funds with a mix of domestic and international funds. Because we are trying to reduce volatility in the portfolio we tend to favour value fund managers, over the market timer type of manager. We stay away from the more volatile funds such as emerging markets and specialty funds. This is because we have found the volatility of them to be too hard on clients' nerves when the investments are part of a leverage program. We also try to avoid Limited Partnership investments, as they are usually illiquid. The same applies to other investments that have poor liquidity. By sticking to funds with low volatility and a long track record the client has more staying power for the long-term completion of the program. Like in real estate where the three things to remember are location, location, location, in investing it is diversification, diversification, diversification.
While these points are just common sense, they are even more important in a leverage program where the underlying debt can cause additional stress. For the 'Nervous Nellies' in your client base, a portfolio of Segregated Funds with their ten-year guarantee can be attractive to provide them with peace of mind. In many provinces an additional disclosure form is required for a leveraged purchase of investment funds. This form, written in a completely negative tone, highlights only the downside potential of leverage. The use of this form is not well enforced in many jurisdictions, but is important to protect the advisor from clients with a selective memory.
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About the author: Peter F. Baigent CFP, CLU, CHFC, RFP. is a Past President of the Canadian Association of Financial Planners for British Columbia, a former Director of the Canadian Association of Financial Planners. He has spoken across Canada on financial planning matters and has taught courses for the Chartered Financial Consultants & Certified Financial Planners degrees. He is the founder of Money Minders Software which produces financial planning software.
