June 8, 2008

The Pros and Cons of Financial Leveraging

Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.
— Archimedes (220 BC)

Leveraging isn't new. Leveraging isn't complicated.

Leveraging means doing more with less. Doesn't that sound environmentally-friendly?

We leverage time, space and money:
  • time: listening to your iPod or radio while commuting (when not eating or drinking or phoning)
  • space: filling your SUV with passengers and garden supplies on different trips
Yesterday, I saw a BBQ lighter with an LED flashlight. You've seen Swiss army knives. Leveraging is all around us. So why such concern with financial leveraging? When used properly, leverage can be quite advantageous.

What is Financial Leveraging?
Simply put, financial leveraging is borrowing to invest. The most familiar use of leverage is using a mortgage to buy a home. In return for a down payment and ongoing payments, you receive money to buy an asset that would otherwise be too expensive. You hope your home will appreciate in value so that when you sell, you realize a profit over what you bought it for (including interest payments).

This is the principle behind financial leveraging. You gain access to a larger amount of capital and invest to earn a return high enough to make a profit. If your investments perform well, the use of leverage can greatly magnify those returns. This is the appeal.

The Risks

When we pick up one end of the stick, we pick up the other.
Stephen Covey
Just as gains are magnified, so are losses. As well, increases in loan interest rates may also cut into your profits or add to your losses. It is important to enter into any leveraging strategy with these risks in mind, and take steps where possible to lower the risk level. For example, investing in a well diversified portfolio will help guard against losses and enhance returns. Choosing a fixed-rate loan over a variable rate will also protect you against rising rates (but not falling rates).

There are a number of ways you can benefit from leveraging:

  • Investment loans: This is leveraging at its most basic. You use borrowed funds to invest with the hope that returns outpace the interest on the loan. In Canada, you can deduct the interest paid on loans for certain investments, which makes this strategy more appealing, and reduces the effect of interest rates eating into your returns
  • RRSP loans: When you borrow to invest in your RRSP, you get two advantages. First, you get the tax deduction for the larger RRSP contribution. Second, the growth of your investment is tax-sheltered within the RRSP which will enhance your returns.
  • Universal Life Insurance: The tax-advantaged status of Universal Life makes it an excellent vehicle for many leveraging strategies. The cash value in the policy provides the collateral. You can borrow to invest. You can also get tax-free retirement income (see the Insured Retirement Strategy, the #2 strategy).
Is Leveraging for You?

Leveraging strategies range from the basic to the very sophisticated and involve varying degrees of risk. Whether or not you could benefit depends on your financial situation, goals and comfort level with taking on risk. It's definitely not for everybody but nothing is.

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3 comments:

Mark Shimkovitz said...

Hey Promod,

I came across your blog post and found it interesting. I'm an advisor with BMO Nesbitt Burns. You might be interested to know that for eligible investors (with min income and net worth), we can provide a loan of up to 100% of the value of a portfolio to invest in one of our managed account's. They are fully open for prepayment and there will be no margin calls if the value goes down. The interest is charged at prime + 0.5%.

Contact me if you would like more information.

Mark

Promod said...

Hi Mark. Thanks for the info. The lack of margin calls gives some peace of mind.

James Morgan - Puritan Financial Advisor said...

Leveraging is all around us. So why such concern with financial leveraging? When used properly, leverage can be quite advantageous.