There’s a fine line between good and evil…

by 4P and Mr. C

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This is the last post in the “Leveraged Investments” series. Check out the previous post entitled “Exit Strategies”.

There’s been a lot of posts on leverage lately in the blogworld so I didn’t think it would hurt to have one more…

Also – I’m in no way advocating anyone use leverage for investments unless they are comfortable with the extra risks.

As Financial Blogger and Tom Bradley pointed out, leverage is an instrument that almost everyone uses when they buy their house. Although most people buy a house to live in, not as an investment, it’s an example of where people are using leverage and they might not even realize it.

If you ask people on the street about how they feel about borrowing to invest they might give you a lot of negative feedback. I suspect this is a holdover from times when margin accounts were the only way to borrow for investing. The problem with margin accounts is that if your investments drop in value enough then you have to come up with cash to pay the difference which is why certain investors were running out of windows in 1929.

My opinion is that leveraged investing can be a useful tool but definitely entails extra risk. However it occurs to me that sometimes the idea of leveraged investments can be a question of semantics.

Consider the following:
Person A gets a $200k mortgage on his house with a 25 year amortization. After five years, his mortgage is $185k and he also has $10k in cash that he has saved. This person decides to invest the $10k into a dividend stock, let’s say…BMO. So now he has a $185k in mortgage and $10k of stock.

Person B also gets a $200k mortgage on his house with a 25 year amortization. After five years, his mortgage is $175k but he has no extra cash to invest because he has been making extra mortgage payments. This person decides to borrow $10k from his secured line of credit and buys $10k of BMO as well and gets the tax rebate on the interest paid.

According to popular wisdom, person A is the epitomy of responsible investing using good old cash to buy his stock. Person B on the other hand has made a deal with the devil and plunged into leveraged investing.

So what’s the difference between the two? The only difference I can see is that Person B can write off his interest on his investments and Person A can’t. Obviously there are interest rate differences but I’m ignoring those since they shouldn’t be too significant.

Moral is – if you don’t make extra payments on debt and use cash to do investments then you would be better off to put that cash into the mortgage and then borrow it out again for those investments and get the tax rebate.

And yes, I realize that this logic was the genesis of the Smith Maneuvre but rest assured that I don’t recommend that particular strategy.

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{ 11 comments… read them below or add one }

1 moneygardener

Good post.

You hit it on the head. Mortgages are viewed differently…period. Mortgages are viewed as a necessary, responsible, evil. While borrowing to invest is just plain evil in most people’s minds.

2 FinancialJungle.com

Back when we used to own a house, we borrowed 100% of our investment from HELOC. That’s what person A should’ve done. 100% may sound scary at first until you compare the dollar figure with your overall net worth. If you’re worth $400k, and leverage 100% in your $20k portfolio, it’s no big deal.

3 Canadian Capitalist

I wouldn’t call either one responsible because I’d say Person A should use the extra cash to pay down the mortgage and Person B should continue doing so.

The reason I am negative about indiscriminate use of leveraged investing is that it amplifies all the behavioural traps investors fall into. It is hard enough for investors to grapple with market risk and stay invested during a down turn. It is even harder when you have borrowed money to do so.

4 Canadian Capitalist

If leverage is such a no-brainer, why is it recommended for everyone now, after 4 years of market gains and ultra-low interest rates? Let’s see how many think it is a great idea in the next bear market.

5 TheFinancialBlogger

I’ve been looking at people doing leverage since early 2003 (which was only the beginning of the bull market). Leverage strategies are always promoted. They were definitely less popular in 2000-2001 but still, it was actually the best timing to leverage.

With mortgage interest rates so low, I guess most of us can do better than 5% a year (without even counting the tax advantage). Especially if you consider that your mortgage will follow you for a good 15 years (25 to 30 for most people).

6 Q-Cash

My question is this:

With interest rates so low now and the possibility for increases in the near future, does it make sense to take out a traditional mortgage and invest the proceeds, thus freezing your interest rates for the next few years, while investing the proceeds?

7 FourPillars

I think it’s important for each person to do a proper analysis on their own situation and decide if leveraging is an option.

The example I gave was just to illustrate a point but there really isn’t enough information to be able to determine if either person should be leveraging or investing in equities at all. We don’t know their age, income, expenses, financial goals etc which are all part of the equation.

Mike

8 FourPillars

Q-Cash – I think locking in rates is a good idea. It’s also not written in stone that you have to keep the loan long term, if you think there is a good value to be had, you can borrow to buy some stock and then pay off the loan over a few years…or even a few months if possible.

9 ThickenMyWallet

At the end of the day, leveraging has only the meaning you give to it. For some, it is a great tool. For others, it should be avoided. The point of my post earlier this week is not that leverage is good or bad but you have to look at the context of every situation before attributing meaning to whether leverage is appropriate to one person or another.

10 Sandeep Patil

Leveraging is a double edged sword, can be good or bad depending on the circumstances.

11 AJ

Mr. C: Read all the posts and found them very interesting. Many things have changed since the original posts in the series ‘Leveraged Investments’ have been published. Global markets crashed and still volatile, we went through a recession (still not out of the woods), currently benefiting from low interest rates etc. Is there an article out there that reflects these new realities with regard to leveraged investments? I am seriously considering setting up a leveraged investment portfolio and would like to see whether the recent changes are more favorable compared to 2007.

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