The risks of leveraged investing

Every once in a while I come across an investor who was convinced to borrow money and invest the loan proceeds. This was presented to them as a smart way to build their net worth and reduce their tax bill at the same time.

There are a number of financial organizations that are known to encourage their financial advisors to recommend leveraged investing as a way of building their assets under management. How else can one get a prospective client with few or no investment assets to make an investment that will generate a sizeable commission?

I came across an example of such a case recently, and present it to you along with information about the strategy that you should read thoroughly before leveraging to invest.

Investment loan snapshot

(A) Initial loan value: $50,000
(B) Market value $41,358
(C) Current loan balance $49,052
(D) After tax interest cost since inception (2007 to present): $4,625

Total loss if strategy closed out $12,319 [$49,052 (C) – $41,358 (B)] + $4,625 (D)

So, the client has invested $4,625 in the form of loan payments, and if she wanted to close out the strategy now should would experience a loss of $12,319.

Leveraging lesson #1 – If the investments go down in value and you have borrowed money, your losses would be larger than had you invested using your own money.

Clearly, closing out the strategy now will only trigger the loss. If the investor can afford to continue making the loan payments, they would be wise to hang in there until the portfolio recovers in part or whole.

Now, if the investor had not borrowed to invest, but simply invested cash, the portfolio, which has declined 17%, would need to grow by 21% to break even. Unfortunately, the leveraged strategy raises the break-even hurdle rate to 42% because of the additional after tax cost of the loan.

Lesson #2 – If the investments go up in value, you may still not make enough money to cover the costs of borrowing.

Here is the full summary that I share with clients when they ask about leveraging.

Is leveraging right for you?

Borrowing money to invest is risky. You should only consider borrowing to invest if:

• You are comfortable taking a high level of risk.
• You are comfortable taking on debt to buy investments that may go up or down in value.
• You are investing for the long-term. (20+ years).
• You have a stable income.
• You do not have any non-deductible debt such as credit cards, lines of credit, car loans or mortgage.
• You have maximized your RRSP and Tax Free Savings Account contributions.

You should not borrow to invest if:

• You have a low tolerance for risk.
• You are investing for a short period of time.
• You intend to rely on income from the investments to pay living expenses.
• You intend to rely on income from the investments to repay the loan. If this income stops or decreases you may not be able to pay back the loan.

You can end up losing money.

• If the investments go down in value and you have borrowed money, your losses would be larger than had you invested using your own money.
• Whether your investments make money or not you will still have to pay back the loan plus interest.
• You may have to sell other assets or use money you had set aside for other purposes to pay back the loan.
• If you used your home as security for the loan, you may lose your home.
• If the investments go up in value, you may still not make enough money to cover the costs of borrowing.

Tax considerations

• You should not borrow to invest just to receive a tax deduction.
• Interest costs are not always tax deductible. You may not be entitled to a tax deduction and may be reassessed for past deductions. You may want to consult a tax professional to determine whether your interest costs will be deductible before borrowing to invest.