Those of you who have been to my Intro to Saving and Investing workshop are familiar with the concept of Financial Capital and Human Capital.
(Haven’t been to that workshop yet? Why the heck not??? Check out upcoming dates here.)
To recap, Human Capital is your ability and desire to earn money, while your Financial Capital is your money earning money for you. If you are just starting out and have no money saved or invested, then you have no Financial Capital. If you have $10,000 or $100,000 or $1,000,000 invested and growing, then you have Financial Capital. A big part of financial planning is figuring out how to grow our Financial Capital so that it is making money for us and eventually over the long run we no longer have to depend on our Human Capital to make money.
One of the challenges (especially when we’re just starting out) is that it can take a long time to get our Financial Capital going–or at least it can seem that way. If you’re putting away $100/month into your TFSA, it might feel like it’s going to take forever for that to add up to anything significant. Even if you’re able to save more than that, it can take a long time to grow. Luckily, there is a fantastic tool you may be able use to help boost your Financial Capital and give yourself a leg up on your savings; that tool is called Leveraged Investing.
Put simply, leveraged investing is borrowing money in order to invest. Think of it like borrowing money to buy a home (like a mortgage). Most people don’t have a million dollars up front to buy a home so they leverage other people’s money by borrowing it, buying the asset up front, and then paying it off later. They gain the asset immediately and reap the benefits over time. Leveraged investing works on the same principles except instead of borrowing to buy a home, you’re borrowing to buy another asset: investments. Over the long term, your asset can grow far more than what you would have had simply by putting your monthly savings in over the same time frame.
How it works:
Step 1 – You need to qualify for a leverage loan, which is a special type of loan set up just for investment purposes.
Step 2 – The money is then invested into a qualified investment in a non-registered account, and you begin making monthly payments. These can be either interest-only payments or interest plus principal, and the interest rate can be either variable or fixed, depending on how you set up the terms of the loan.
Step 3 – Each year, you claim a tax deduction for the interest you’ve paid on the investment loan (yay tax deductions!).
Step 4 – After 15+ years, once your investment has grown, you sell the investment, pay off outstanding loan (if any), pay tax on the gain, and keep the profit.
You might consider this strategy if:
– you’re already maxing out your RSP and TFSA space
– you want to give your long-term savings a boost
– you want another tax-friendly savings vehicle
– you are comfortable with investment risk and market volatility
– you have a solid financial plan in place and can commit to a long-term plan
This strategy is NOT for you if:
– you are not sure about your ability to commit to a long-term plan
– you are not comfortable with investment risk and/or are a conservative investor
– you do not have a solid financial plan in place
The reason we say that a person needs to be comfortable with risk for this kind of strategy is not only because it involves the usual market risks (you will be invested in equity markets). It is also because you are borrowing to invest. If for some reason the investment goes sideways, you still have that loan to pay off, and that increases your risk. Now with that said, we are mitigating the risk as much as possible through various methods such as good asset allocation, diversification, and long-term strategy. This is not meant to be a short-term plan but a long-term one, and over the long-term much of the risk diminishes. But we do not want to downplay the fact that investing borrowed money is more risky than investing your own money. Go in with eyes wide open.
Now the fun stuff–an example!
Let’s say you have $300/month to put into savings. You’re already maxing out your RSP and TFSA so your $300/month will go into a taxable investing account. You invest that $300/month for the next 20 years, earning an average of 6% return over 20 years. At the end of 20 years you sell the investment and pay the tax on the growth, you will end up with roughly $73,000 (we’re assuming a 40% marginal tax rate in this example).
Your twin sister also has $300/month to put into savings and has also maxed out her RSP and TFSA. But instead of putting her $300/month into a regular investment account, she decides to take out a $90,000 interest-only leverage loan and invest the loan money into the exact same investment mix that you have selected for your investment account, earning the same 6% return. The interest on her $90,000 loan is currently 3.95% (July 2017), which works out to $296/month that she is paying into her plan (almost exactly the same as your $300/month). So you’re both putting the same amount in per month, but she’s starting her nest egg with $90,000 and you’re starting with 0. On top of that, she’s getting an annual tax deduction for her interest payments. After 20 years when you have your $73,000 your sister will end up with a whopping $159,000. Same rate of return, same savings rate, same tax rate, twice as much money in the end. However, she took on extra risk. In addition, over those 20 years there would have been changes in the interest rates so her monthly payments may have fluctuated above or below $300/month, where yours would have stayed steady. Still, she came out far ahead. Check out the visual:
Which would you rather have?
Pretty cool, right?
If you would like to know more about whether this might be a good strategy for you, I’m happy to talk to you more about it! Contact me here.