This is the first post in the “Leveraged Investments” series.
There has been a lot of discussion lately in blog world about leveraged investing so I thought I would add my take on the situation.I decided at the beginning of this year to look into the feasibility of using some leverage to buy dividend stocks.I figured with my long time line for this project, the favourable dividend taxation rates, and the tax deduction on the interest, that there was a reasonable chance to implement an investment plan which would eventually pay for itself from a cash flow point of view and provide an eventual net profit from the dividend flows and capital gains at the conclusion.
I have three posts prepared on this topic, today’s post outlines “the plan”, next post will cover all the risks (and there’s a lot of them) and some steps I’m taking to manage the risks, and the last post will look in depth at my analysis of my personal interest rate risk which includes my mortgage as well the investment loan.
The basic plan is to use my home equity line of credit to buy dividend stocks in a taxable account. Stocks would be Canadian dividend stocks, strong record of dividend increases, great companies.Safety of the companies is of utmost concern.
The main reason I was inspired to think of this plan is because of the incredible record of dividend increases that a lot of these companies have had (10% to 20% over the last 10 years).I’m well aware that this is an aberration however that’s what got me interested in this type of investment in the first place.
The other reasons I’m keen on the plan are because of the tax deductibility of the interest on the investment loan and the light tax on dividends. Another attraction is that if the plan is at least moderately successful, it won’t cost me anything to implement.
Here is a model of a scenario that I’ve analyzed.In actual practice I wouldn’t buy $100k all at once, accumulation will be much more gradual and I don’t have a specific upper limit.
Some numbers – my marginal tax rate is 43%, tax rate on dividends is 21%. I set up a model where I buy $100k of stock yielding 3.1% and the dividends increase 5% per year. Interest rate is 6% and never changes.All figures have been discounted to 2007 dollars using a 3% discount rate.
$6000 is paid in interest each year, $2603 tax rebate received each year.
In the first year the dividend income is $3100, after tax dividend income is $2449 so the profit for me is the interest – tax rebate – net dividend income = -$948 for the first year.
In the second year, the dividends have increased by 5% so the annual profit = -$826.
In year eight the annual profit is now positive at $49 and it continues to grow after that.
At the end of year 14 – the total of all the cash flows in today’s dollars add up to $436 which means that at that point in time, my overall cost at that point is zero and I have $436 in profit from the dividends.
By the end of the plan (25 years), the total of all the annual net profits/losses from dividends is $17,866 in 2007 dollars.To calculate the potential capital gain I took the gross dividend income in year 25 ($9,998), divide by 0.05 (I’m assuming a 5% yield) which gives me a $200k valuation of the equities.I calculate that if I were to sell all the stocks at that time and pay off the loan I would have a 2007 present value of $38,500.Adding the net dividend income + net gains gives me $56,374 in 2007 dollars.
Bottom line is that in this model I’m paying only $3620in today’s dollars over the first seven years to get things started. Even in year one, 84% of the interest cost is covered by the tax rebate and net dividend. By the end of year 8 my cash flow is now positive and by year 14 I’ve broken even in that the annual profits I’ve received from the dividends have paid for my initial costs.If the plan works exactly as the model does then I would make a profit equivalent to $56,374 in 2007 dollars.
You might have noticed that like most leveraged plans this one didn’t mention any of the risks involved….that will change tomorrow when I will go through every risk I could think of and how I’m planning to mitigate those risks.
Here is my spreadsheet for this model: Div Sheet
See the next post in this series “The Risks”.