What’s wrong with leveraging?

Financial Post, October 9, 2012

Every once in a while a client walks into my office and asks me about a borrow-to-invest strategy that their uncle/friend/neighbour has gotten themselves into. The usual story is how this person borrowed a sum of money against the equity in their home, invested the money into stocks, mutual funds, or an insurance policy, and wrote off the interest payments on the loan against their personal income taxes. It seemed like a fool proof plan when the “advisor” presented the data.

The problem is in the execution of the strategy

When approached with a typical borrow-to-invest strategy investors are presented with quite a compelling story. Advisors will show how, over the long run, a modest $100,000 investment can grow to millions of dollars over a 30-year period. Couple that with the fact that one can now borrow against their home at historically low rates, then potentially write-off the interest charges against their personal taxes at year end, one would wonder why everyone isn’t doing this. The fact of the matter is that it is not that simple, and while the strategy works perfectly in the marketing brochures it can turn into a disaster in real life.

The biggest problem I find with this strategy is that many people who enter these investment programs believe that the tactic of front-loading their retirements with a loan means that they no longer have to save their current earnings. This is absolutely incorrect.

Let’s look at a hypothetical example: Suppose you were to borrow $100,000 on January 1st, 1980 against the equity of your home and make an immediate investment in a balanced portfolio of 40% Canadian bonds, 20% Canadian stocks, 20% US stocks and 20% International stocks.

Let’s assume that the loan attracts interest at the average 5-year mortgage rate (as per the Bank of Canada’s records). Ignoring taxes, the portfolio will have grown to $2,197,977 by the end of 2011, and assuming you were to personally pay your interest payments every year this strategy would have attracted interest of $305,700. Your overall investment would have been $405,700, leaving you with a net investment of $1,792,278 or a 6.97% compound rate of return on your investment over the 32-year period, not too bad.

Compare that with the more traditional strategy of simply investing the $100,000 in 32 equal increments over the same period. The traditional strategy would have left you with no debt and no interest, but a total portfolio of only $543,669, less than half of the borrow-to-invest strategy (and this does not even consider the tax benefits of writing off the interest payments). The compound rate of return on this strategy would be 9.29% annually.

So it’s a shoe-in, borrowing to invest is better right? Wrong; or at least in my opinion isn’t. The problem is not in the numbers, as they evidently work out quite neatly on a spreadsheet.

The problem is in the execution of the strategy. The strategy only works when you have the discipline and economic means to make the interest payments yourself over the entire course of the investment horizon. This means that over a very long period of time you cannot lose your job, cannot have a bad year, cannot have any financial hiccups. This is not realistic.

The approach works for the people who have the means to make it work; people who earn a high and consistent level of income, and people with the discipline to set the appropriate amount of money aside to make their interest payments and fully benefit from the tax deductions.

I find that most people who are attracted to this strategy are either families without the means to make the payments themselves or high income earning professionals that spend every penny they make funding a lavish lifestyle. These people fall into the trap of believing that they can simply put their retirements on auto-pilot and forget about financial discipline.

What I see happening to many of these people is that they allow the strategy to run itself. Rather than setting aside enough money to pay the interest, they simply allow the interest to be deducted from the investment portfolio believing that they will achieve a similar result.

This is not the case; if one were to follow the same assumptions as above but deduct the annual interest payments from the portfolio year over year, the ending portfolio would be a modest $231,938 (without paying down the $100,000 debt). This would yield a compound rate of return of merely 2.66%. Compare that to the Canadian inflation rate seen over the same time period (3.38%) and you will quickly see that the only parties benefiting from this strategy are the bank that made the loan and the advisor that scooped up the commissions.

Couple the above situation with the fact that your investments can be locked in for years depending on what type of commission or sales charge your advisor takes, as well as the fact that liquidating the portfolio in the event of financial hardship can lead to hidden fees and taxes the rosy picture painted in the marketing brochures begins to show its true colours. In the end there really is no easy money, what works on paper rarely ever plays out perfectly in real life.



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