As an entrepreneur, you know the value in borrowing money to grow your business. So why not consider borrowing to grow your investments? The concept of leveraging has been around as long as money itself. Done wisely, it can help you achieve a higher absolute rate of return and accelerate your wealth-building over the long term. The catch? While leveraging can increase your gains, it can also magnify your losses. The key to successful leveraging is in managing your risk.
“Leveraged investing is a great way to add some octane to your investment program,” says Paul Green, president of Green Financial Group in Woodstock, Ont. Given the low cost of borrowing these days, it’s an even better opportunity.
Here’s how it works. Say you borrow $100,000 at an annual interest rate of 4% to purchase shares in a public company, and the share price increases 10% over the year. Your net return is 6%, or $6,000—a lot more than you’d have made with no investment at all. Even better: the interest charged on investment loans for non-registered accounts is, with few exceptions, 100% tax-deductible, knocking down your taxable income by $4,000.
But leveraging is not for everyone. Market declines, rising interest rates and cash-flow crunches can all threaten your investment. You’re in a good position to take advantage of leveraging if you have little existing debt, are investing outside your RRSPs and have enough stable cash flow to service the debt and provide a buffer against any losses.
Still game? Here’s how to make leveraging work for you:
Borrow less than you can afford. Start by determining your available monthly cash flow and then divide that in half to ensure you can cope with any unforeseen changes in your ability to make monthly interest payments, if not pay down the principal. As a rule of thumb, experts recommend limiting your borrowing to 10% to 20% of your net worth.
Choose the right type of loan. Typical options are an investment loan, a margin account or a line of credit. Both investment loans and margin accounts are subject to margin calls, which force you to pay the lender or deposit into your investment account the amount by which your investment’s value falls below a predetermined amount, often the principal remaining on your loan. John Nicola, president of Vancouver-based Nicola Financial Group, says that’s why many investors prefer to leverage off a credit line. When secured by the equity in your home, it’s probably the cheapest way for you to borrow.
Invest wisely. Choose equity mutual funds, which give you a liquid, diversified asset with the potential to generate big returns that balance the cost of the loan over time. Even if the management expense ratios (MERs) of equity funds make them more expensive than individual equities, “most people don’t know how to pick stocks, and they definitely don’t know how to sell them,” says Green.
Segregated funds are another option. Seg funds are insurance contracts underpinned by mutual funds, and they guarantee the holder a return of 75% to 100% of the principal at the end of the holding period (typically, 10 years). At that point, you’ll get back most or all of the money you borrowed even if the fund dips in value. But watch out for the higher fees-segregated funds often charge up to 1% on top of the MER for insurance costs, which could make them too expensive to cover your borrowing costs.
Invest for the long term. Count on a seven- to 10-year horizon to increase the likelihood of positive returns. Of course, if your investment goes through the roof in, say, three or four years, there’s no reason you shouldn’t take your profits and run.
Avoid registering your leveraged investment, so you can deduct the cost of borrowing. After all, why pay taxes when you don’t have to?