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Leveraging - The Basics

"Give me a lever long enough and a place to stand, and I could lift the world." Archimedes (287-212 B.C.)

In this article we are going to look at the basics of the use of leverage to increase your net worth. Leveraging is a big topic so we are going to divide it into three parts:

  1. Leveraging - the basics;
  2. Leveraging - the RRIF meltdown; and
  3. Leveraging - compared to dollar cost averaging.

What I won't talk about is which investments you should buy, where to obtain financing or if leveraging is an appropriate strategy for you. These are best discussed with the qualified financial professional that normally assists you with your financial planning. What I will say about financing is that it is very important to ensure that borrow at the lowest rate possible. Just as you would shop for a mortgage, shop for your leverage financing. It is possible to get prime when leveraging.

Very simply, leveraging is borrowing money to invest. Some people like to call it OPM (Other People's Money). Borrowing to invest results in a couple of things. The first is that it magnifies your gains or losses. The second is that the interest that is charged to you is deductible on line 221 of your tax return in much the same way that an RRSP is deducted on line 208. They both serve to reduce the income on which you must pay taxes.

Let's take a basic example. A person in the 50% marginal tax bracket borrows $100 for one year paying 10% interest, or $10. At the end of the year this person sells his investment for $110 making a profit of $10. Did this person make money, lose money or come out even?

It seems pretty obvious doesn't it? It cost $10 and he made $10 - he broke even right? I don't think so. Let's look at the after tax cash picture. We have to look at what's left over after doing his tax return. He had a $10 capital gain, 50% of which is taxable. At the 50% marginal tax rate the amount of tax owed is $2.50. So out of the $10 gain, he gets to keep $7.50. On his tax return he also deducts the interest expense. Out of the $10 that he paid in interest, the government gives him back 50% or $5.00. So his after tax cost is $5.00 and his after tax revenue is $7.50 for a cash - in his pocket - gain of $2.50.

If our investor has $2.50 in his pocket he didn't break even - he made money. Leveraging is about more than simply magnifying gains or losses, it is also about taxes and how to reduce them. If you understand the example above you are well on your way to understanding leverage.

There is one note that I should make at this point. Interest borrowed to earn income is deductible. If your fund company never sends out a T Slip for earned interest, dividends or capital gains, it is likely that your deduction will be disallowed. For this reason some of the tax efficient funds may not be the best choice when using this strategy.

If you have (had) a mortgage, you are (were) already involved in a leverage plan. For example, if you purchase a house for $100,000 with a $10,000 down payment and two years later you sell the house for $110,000, what was your profit a: 10%, or b: 100% ? The answer is 100%. What if you sold your house for $95,000? If you sold your house for $95,000, you had a 50% loss on your original $10,000 investment.

Many Canadians have done exactly this, leveraging themselves 10 to 1 in order to purchase a house. What is more, in order to have the $700 per month mortgage payment, many Canadians first had to earn $1,400, as interest incurred to buy a house is not tax-deductible.

Finally, let's look at a more likely example when investing in mutual funds:

Assumptions:

Investment: $100,000
Growth Rate: 10%
Marginal Tax Rate: 50%
Cost to Borrow: 8%
Period: 25 years

Results
Monthly payment: $781
Total After-Tax Out of Pocket: $167,445
Total Growth: $1,083,471
Tax Liability if Sold in 25th Year: $245,868
In Your Pocket: $837,603


 

 

 

 

 

 

 

 

Left Over

 

 

 

Increase in

Deductible

Tax

Net

Tax

After Loan &

Year

Growth

Loan Bal

Net Worth

Interest

Refund

Cost

Liability

Taxes Paid

1

$110,000

$98,632

$11,368

$8,000

 

$9,368

$2,500

$8,868

2

$121,000

$97,155

$23,845

$7,891

$4,000

$5,368

$5,250

$18,595

3

$133,100

$95,559

$37,541

$7,772

$3,945

$5,423

$8,275

$29,266

4

$146,410

$93,836

$52,574

$7,645

$3,886

$5,482

$11,603

$40,971

5

$161,051

$91,975

$69,076

$7,507

$3,822

$5,546

$15,263

$53,813

6

$177,156

$89,965

$87,191

$7,358

$3,753

$5,614

$19,289

$67,902

7

$194,872

$87,795

$107,077

$7,197

$3,679

$5,689

$23,718

$83,359

8

$214,359

$85,450

$128,908

$7,024

$3,599

$5,769

$28,590

$100,319

9

$235,795

$82,919

$152,876

$6,836

$3,512

$5,856

$33,949

$118,928

10

$259,374

$80,184

$179,190

$6,633

$3,418

$5,950

$39,844

$139,347

11

$285,312

$77,231

$208,081

$6,415

$3,317

$6,051

$46,328

$161,753

12

$313,843

$74,042

$239,801

$6,178

$3,207

$6,161

$53,461

$186,341

13

$345,227

$70,597

$274,630

$5,923

$3,089

$6,279

$61,307

$213,323

14

$379,750

$66,877

$312,873

$5,648

$2,962

$6,406

$69,937

$242,935

15

$417,725

$62,859

$354,866

$5,350

$2,824

$6,544

$79,431

$275,434

16

$459,497

$58,520

$400,977

$5,029

$2,675

$6,693

$89,874

$311,103

17

$505,447

$53,834

$451,613

$4,682

$2,514

$6,854

$101,362

$350,251

18

$555,992

$48,773

$507,219

$4,307

$2,341

$7,027

$113,998

$393,221

19

$611,591

$43,307

$568,284

$3,902

$2,153

$7,215

$127,898

$440,387

20

$672,750

$37,403

$635,347

$3,465

$1,951

$7,417

$143,187

$492,159

21

$740,025

$31,028

$708,997

$2,992

$1,732

$7,636

$160,006

$548,991

22

$814,027

$24,142

$789,886

$2,482

$1,496

$7,872

$178,507

$611,379

23

$895,430

$16,705

$878,725

$1,931

$1,241

$8,127

$198,858

$679,867

24

$984,973

$8,674

$976,299

$1,336

$966

$8,402

$221,243

$755,056

25

$1,083,471

$0

$1,083,471

$694

$668

$8,700

$245,868

$837,603

Not everyone is in the 50% marginal tax bracket, not everyone is convinced that you can earn 10% and not everyone is willing to go out and borrow $100,000 to invest. You may want to play with some numbers of your own. In fact I would encourage you to try out your own worst case scenarios. If you have access to a copy of Microsoft excel you can plug in your own scenarios here: http://www.rrsp.org/spreadsheets.htm . Click on the "Leveraging Scenarios" link. Please be sure to read the disclosure document page included with the spreadsheet program. Have fun - Doug.


Leveraging - The RRIF Meltdown

This is a very aggressive strategy and it is not suitable for all investors. Before considering such a strategy, discuss it with the qualified financial professional that normally assists you with your financial planning.

Many people will look at the example used in the previous article and exclaim "I don't have $600-$800 left over at the end of the month to pay for anything, let alone a leverage loan." A way around this problem is with the RRIF meltdown. It's called a RRIF meltdown, but it works with funds from an RRSP as well.

The meltdown is a very simple plan. You want to leverage but you don't want interest payments to affect your lifestyle. The answer is to take the funds from your registered plans. The first reaction is "But won't I have to pay tax on money taken out of an RRSP or RRIF?". The answer is yes. This is offset by an interest and carrying charge deduction at line 221 of your return. If orchestrated properly, the net effect is zero.

The next question is "Why would I take money out of my RRSP to buy leverage investments?". In order to properly answer this question we need to answer another question - "When it is time to retire, where is it better to have your investments - inside or outside an RRSP or RRIF?". Let's look at the advantages and disadvantages.

The major advantage to having investments inside the RRSP is tax-free compounding. This is especially important during the accumulation stages of your financial plan. The major disadvantage to an RRSP is that all withdrawals from the plan are treated as ordinary income including amounts originally contributed and income earned on those amounts. These withdrawals are taxed at the highest rate. Capital gains and dividends lose their special tax treatment in registered plans. Another disadvantage is that at age 69, your RRSP must be converted to a RRIF and you are required to withdraw funds from your RRIF and pay tax on the money withdrawn whether this is convenient for you or not. One more disadvantage of registered plans are the limitations on foreign content in registered plans.

The disadvantage of investing outside an RRSP is the fact that tax must be paid on all income that the investments earn. Even though this is the case, with the exception of interest, investments kept outside registered plans have certain tax advantages. With dividends there is the dividend tax credit. With capital gains, only 50% of the gain (not your capital) is taxed. This is best illustrated with an example. Let's assume that you are in the 50% marginal tax bracket and you take $10,000 out of an RRSP. The tax owed is $5,000 and you are left with $5,000 in your pocket. If you invest $5,000 outside your RRSP seven years later at 10% it grows to $10,000. If you sell it, you must pay tax on 1/2 the capital gain of $5,000, or $2,500. At the 50% marginal tax rate, the tax owed is $1,250 leaving $8,750 in the hands of the investor. I think we would all agree that it is better to have $8,750 in after tax money than $5,000.



Leveraging Compared to Dollar Cost Averaging

If you want to refresh yourself on the topic of "Dollar Cost Averaging" before comparing it to leveraging, you can look at a previous article here.

To compare dollar cost averaging with leveraging I'm going to use an example. These are the assumptions:

  • Amount invested for leveraged investment: $50,000
  • Growth rate: 10%
  • Cost to borrow: 8% (interest only)
  • Marginal tax rate: 50%


 

 

 

 

 

 

Left Over

 

 

Deductible

Tax

Net

Tax

After Loan &

Year

Growth

Interest

Refund

Cost

Liability

Taxes Paid

1

$55,000

$4,000

$2,000

$2,000

$1,250

$3,750

2

$60,500

$4,000

$2,000

$2,000

$2,625

$7,875

3

$66,550

$4,000

$2,000

$2,000

$4,138

$12,413

4

$73,205

$4,000

$2,000

$2,000

$5,801

$17,404

5

$80,526

$4,000

$2,000

$2,000

$7,631

$22,894

6

$88,578

$4,000

$2,000

$2,000

$9,645

$28,934

7

$97,436

$4,000

$2,000

$2,000

$11,859

$35,577

8

$107,179

$4,000

$2,000

$2,000

$14,295

$42,885

9

$117,897

$4,000

$2,000

$2,000

$16,974

$50,923

10

$129,687

$4,000

$2,000

$2,000

$19,922

$59,765

11

$142,656

$4,000

$2,000

$2,000

$23,164

$69,492

12

$156,921

$4,000

$2,000

$2,000

$26,730

$80,191

13

$172,614

$4,000

$2,000

$2,000

$30,653

$91,960

14

$189,875

$4,000

$2,000

$2,000

$34,969

$104,906

15

$208,862

$4,000

$2,000

$2,000

$39,716

$119,147

16

$229,749

$4,000

$2,000

$2,000

$44,937

$134,811

17

$252,724

$4,000

$2,000

$2,000

$50,681

$152,043

18

$277,996

$4,000

$2,000

$2,000

$56,999

$170,997

19

$305,795

$4,000

$2,000

$2,000

$63,949

$191,847

20

$336,375

$4,000

$2,000

$2,000

$71,594

$214,781

21

$370,012

$4,000

$2,000

$2,000

$80,003

$240,009

22

$407,014

$4,000

$2,000

$2,000

$89,253

$267,760

23

$447,715

$4,000

$2,000

$2,000

$99,429

$298,286

24

$492,487

$4,000

$2,000

$2,000

$110,622

$331,865

25

$541,735

$4,000

$2,000

$2,000

$122,934

$368,801

On an after tax basis this investment cost 25 x $2,000, or $50,000 and we ended up with $368,801 in after tax, loan paid off, cash.

If I were to take $2,000 per year and using dollar cost averaging were to invest this for 25 years at 10% I would end up with $216,364. We still have to pay tax on the capital gain which is $216,364 - $50,000 = $166,364. Half of this is taxable at the 50% marginal tax rate, or, $41,591 in taxes owing. So from the $216,364 we remove the taxes owing and are left with $174,773.

Most would agree that $368,801 - the leveraging option is better than $174,773 - the dollar cost averaging option. There is a problem however. One of the nice things about dollar cost averaging is that when prices are high, your investment doesn't buy as many units, and when prices are low, you pick up investments at bargain basement prices. So it's very difficult to predict how a dollar cost averaging investment will actually work out. In fact, the dollar cost averaging option may do much better if there is a slump in investment prices followed by a sharp gain.

Personally, if you want my two cents worth, leveraging should be accompanied by a dollar cost averaging plan. Should interest rates shoot up, you have the maneuverability to slow down on the dollar cost averaging plan in order to comfortably make your leveraging payments. Also, there are just too many positive things about dollar cost averaging not to be involved in it - see article.