In some circles leveraging—or borrowing to invest—is a taboo subject. I find that funny, because there is much less controversy when people borrow to:
- Buy a car;
- Pay off credit card debt;
- Take a vacation.
Let’s talk about leverage. If you borrow $100,000 at 5%, what rate of return would you have to earn on your investments to break even? Most people would agree that the answer is 5%. So, if you borrow $100,000 at 5% and paid $5,000 in interest costs then that would mean you would have to make $5,000 on your $100,000 investment to break even, which is 5%. Right?
That answer is wrong!
The break-even return on investments is lower than the borrowing cost when you take the following into account:
- Simple vs. compound interest over time;
- The interest tax deduction and;
- The tax deferral on the investments.
When you make annual interest payments on a loan, this is considered simple interest. For example, in the first year, you would pay $5,000 in interest charges on a $100,000 loan at 5%. In the second year, you’d have the same interest charge because the loan is still $100,000. Contrast that with a $100,000 investment earning 5%. After the first year, you’ll have $105,000. In the second year you’ll have $105,000 plus 5%, which brings the running total to $110,250—and up it goes each following year. This is the effect of compound interest.
In summary, when you make annual interest payments on a loan, simple interest applies, whereas investments compound. The longer you hold the investments, the greater the compound effect and the lower the return needs to be on the investments to break even.
Now, consider the tax deduction. When you borrow money to invest, the interest cost is considered a carrying charge on your tax return, which creates a tax deduction no different than making an RRSP contribution. Therefore, if your marginal tax rate is 30%, your after-tax cost of borrowing is 3.5%. The professionally recommended strategy is to then take the tax savings and reinvest it or invest it to pay down the non-tax deductible debt.
The final point is the tax efficiency of your investments. The less tax you pay on your investments as they grow, the more money you have invested, and the more the return compounds over time.
When it comes to leverage don’t think just about investment accumulation but also think about how you can use the interest tax deduction. Here are a few tips:
- Will it reduce your income so you can get more of the Canada Child Tax Benefit, GIS, OAS, and the Age Credit?
- Will the tax deduction offset the tax owed on RRIF or other tax sheltered investment withdrawals?
- Can you use the tax deductions to pay off your mortgage faster and accumulate investments (i.e. the Smith Manoeuvre).
- Interest on the interest that is tax deductible is also tax deductible so consider paying off non-tax-deductible debt before making interest payments on your leveraged loan.
When used correctly, a HELOC can be a primary tool for tapping into your home’s equity and leveraging that equity for the accumulation of wealth.
For advice on proper mortgage planning and real estate investment contact Steven Porter CRMS ABR SRES, Certified Luxury Home Mortgage Advisor, Mortgage Planner with Mortgage Architects. (905)875-2582, steven@1800Mortgages.ca