There's a new family in town. They're my neighbours, and I met them for the first time this past summer when their dog paid a visit to our home and stole my underwear. (No, I wasn't wearing it at the time.) It was out on the clothes line drying (Carolyn likes to air dry our laundry from time to time).
That neighbour is Glenn, and we've become good friends. Glenn has been thinking about borrowing money to invest – that is, leveraged investing – and was wondering whether it's a good idea.
"Interest rates are so low that I don't see how it can be a bad idea," he said the other day.
"It's not quite that easy," I replied.
The first things we talked about were the myths of leveraged investing. Let me share the five myths we covered.
Myth 1: All debt is bad
One thing I did agree with Glenn about is that debt in itself is not necessarily a bad thing. In fact, I would classify debt into good and bad. Debt is a little like electricity: It can enhance your life if you use it properly, but can lead to disaster if you're not careful. My view is that bad debt includes high-interest debt that is used for personal consumption for which you can't deduct the interest costs. Credit-card debt is the most common example. Good debt, however, is debt used to acquire assets that will appreciate in value over time (a home mortgage, for example), when the interest cost is low. It's even better when you can deduct that interest.
Myth 2: Leverage is too risky
Make no mistake, leveraged investing does come with risks. It also can come with rewards. The question Glenn needs to answer is this: Is leveraged investing too risky for me to consider as a wealth-accumulation strategy? The key here is to understand the various risks and to decide how you'll mitigate each risk. Can you sleep at night with the measures taken to reduce the risks? I'm going to focus more on the risks next time, but my suggestion is that you talk this over with a trusted adviser who understands the risks and rewards of leveraged investing and who knows you well. I will say this: Any investment strategy, leveraged or not, comes with some risk. The best advice is typically not to avoid investing, but to manage those risks appropriately.
Myth 3: Leveraged investing is only for the rich
Before you embark on any strategy where you borrow to invest, you need to have sufficient cash flow to easily make your payments on the debt. Don't rely on the borrowed money to generate the income to pay off your debt. The wealthier you are, the easier this becomes. If you're not a wealthy person, your cash flow might be less than that of a higher income earner, but this doesn't mean borrowing to invest is a bad idea. What it should mean is that generally you should borrow less than what a wealthy person might borrow. If you understand how leveraged investing works, have managed the risks and are comfortable with the risk-and-reward tradeoff, then you don't have to be wealthy to utilize this strategy.
Myth 4: Returns have to equal your interest costs
There is definitely a break-even rate of return you'll need to achieve if you're borrowing money to invest. The myth is that most people believe that, to break even, your pretax rate of return on the borrowed money needs to equal your pretax interest costs. But that's not correct: Your after-tax rate of return needs to equal your after-tax interest costs. If you're borrowing at, say, 5 per cent, your after-tax cost of borrowing will be something less than 5 per cent if you're deducting your interest. Let's assume your after-tax interest cost is 2.5 per cent. In this case, you'd have to earn 2.5 per cent after taxes annually on your portfolio just to break even. How do you earn 2.5 per cent after taxes? It depends on what type of income you're earning. Capital gains are taxed at half the rates of interest income, so your break-even pretax return is lower if you're earning capital gains – that is, if you have some growth focus in the portfolio.
Myth 5: Interest costs are always tax deductible
If you're going to borrow to invest, it's very important to keep your interest costs tax-deductible. You see, the deduction for the interest you're paying on the loan will save you tax. These tax savings are an important benefit to leveraged investing, and will affect your effective rate of return and break-even rate of return. Generally, you can deduct interest where you borrow to earn income, but if your interest costs cease to be fully deductible, the benefits of the concept are reduced.
I'll talk more about this next time.
Tim Cestnick is managing director of Advanced Wealth Planning, Scotiabank Global Wealth Management, and founder of WaterStreet Family Offices.