4. Leverage always increases risks
- What are the risks of borrowing to invest? Let’s assume the total risk is a combination of the 3 main financial risks – the risk of losing money, the risk of emotional stress, and the shortfall risk of not having enough money to meet your long term goals (e.g. retirement). The first 2 are generally higher with leverage.
- What about the 3rd risk? It’s been said that you can be young and broke, but you can’t be old and broke. Specifically, what is the risk that our money will run out while you are retired?
- Most of what we actually do as financial advisors is help people set and achieve their long term goals, especially retirement. The first experience with a retirement plan is usually quite shocking! Most of our clients are average Canadians, and are surprised to find that they will need $1-1.5 million to maintain their existing lifestyle when they retire. They underestimate how much they actually spend now and then underestimate how much inflation will affect us over the next 40 or 50 years.
- The truth here is that for most of us, the risk of running out of money is far higher if we don’t use wealth building strategies like leverage.
- If you have never had your own retirement plan calculated accurately, you will probably doubt this. You may also be one of those frugal people that spend almost nothing. But if you consider risk as a combination of the 3 main risks, some leverage will actually reduce your overall risk.
5. To make money with leverage, your returns need to be higher than the loan interest rate
- It may seem logical that if you borrow at prime (6%), you need to make at least 6% on your investments to break even. This is wrong for 2 main reasons – the different tax treatment and the fact that the loan interest is the same amount each year (if the loan amount stays the same) while the investment growth compounds on itself.
- Your investment loan interest is 100% deductible each year, while the equity investments give you tax-preferred capital gains. Plus, you can defer them almost forever if you have very tax-efficient investments.
- The break even point for a typical example is an investment return of only 4.5% after year 1, 4% after 7 years, and 3.3% after 20 years. (This assumes a 40% tax bracket and 10% of the investment growth taxed each year – 90% tax efficiency).
- In short, after 7 years, you only need 2/3 of the loan interest rate to break even and after 20 years, you only need just over ½ the loan interest rate.
There are real risks with leverage into equities. They can be minimized, however, with an effective investment strategy, understanding the risk level of your investments, by not taking any distributions out of the investments, and making sure it is a long term strategy.
Implemented properly, once you give up the myths, leveraging into equities combined, with your RRSP’s, can be the best way to achieve your long term goals.
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