Flash Retirement

Leveraged Loans: A Bold Strategy

With a leveraged loan, you borrow money with the sole purpose of investing it. If the net return on investment after tax* is higher than the cost of borrowing the money (the loan rate), you turn a profit. This strategy is not appropriate for everyone because it requires a portfolio made up of 100% growth shares (no fixed-income investments except high performance bonds). Before you increase your risk through leveraging, make sure you're comfortable having a higher proportion of shares in your portfolio.

The interest paid on a loan used to invest in a tax-free savings account (TFSA), registered retirement savings plan (RRSP) or registered education savings plan (RESP) is never deductible.

The term "leverage" refers to the magnifying effect. If the strategy works, you'll magnify your rate of return. If returns are low, the negative impact is also magnified.

*

Tax is calculated on the income generated, minus the tax deductible portion of the costs.


With Financial Leverage
Rate of return10% -10%
Cash on hand $5000 $5000
Amount borrowed $15 000 $15 000
Amount invested $20 000 $20 000
Return on investment $2000 $(2000)
Loan rate 7% 7%
Loan cost $1050 $1050
Return, net of loan cost $950 $(3050)
Return on capital on hand 19% -61%


Without Financial Leverage
Rate of return 10% -10%
Cash on hand $5000 $5000
Amount borrowed - -
Amount invested $5000 $5000
Return on investment $500 $(500)
Loan rate 0% 0%
Loan cost - -
Return, net of loan cost $500 $(500)
Return on cash on hand 10% -10%


As illustrated in the table above, a 10% net return could jump to 19% if the investment is leveraged, but a 10% loss could turn into a 61% loss! You should also be aware that some or all of the loan may have to be paid back over a very short term. If this is the case, you might be able to use your income tax refund to pay back the leveraged loan quickly.

Leveraging can also be used in less complex situations, with no deductible interest and less risk:

  • To finance the purchase of a home
  • To max out your RRSP, assuming your return is higher than the loan rate. Note that saving systematically is a more effective strategy for the fixed-income component of your RRSP, since the rate of return is usually lower than the loan rate. 

Advantages of Leveraged Loans 

  • Over the long term, the return on higher risk investments such as shares should exceed the cost of your loan.
  • The maximum tax rates for dividends (39.998%) and capital gains (26.653%) in 2019 are lower than the maximum deduction for interest expenses (53.305%).
  • The combination of returns and tax treatment can make the strategy pay off over the long term. The Autorité des marchés financiers requires that investors be clearly informed of the risks involved with leveraged loans and sign a statement to this effect.

Disadvantages of Leveraged Loans 

  • Because of the psychological pressure, investors may be tempted to sell their investments when they drop in value. But instead, they should sell high and use the profits to purchase stable or good-growth-potential shares to reduce the risk of eating into their capital.
  • If you take out a leveraged loan, you'll lose money on all fixed-income investments in your portfolio, since their returns are usually lower than the cost of the loan.
  • The return on riskier investments is very volatile and may be negative, even over a longer term (e.g., 5 to 10 years).

    Since the cost of the loan and the rate of return are not related in any way, you can't rely on investment income to pay your interest expenses. The financial markets can fluctuate widely as interest rates rise.
  • Although interest expenses on your loan are sometimes deductible, the rules are currently under review by the Canada Revenue Agency and are subject to change. In Québec, the annual deduction of interest is limited to declared taxable returns.
  • The Canadian Securities Institute (CSI) considers this strategy risky even if interest is deductible.
  • There may be a provision in the loan contract requiring that some or all of the loan be paid back if your investment drops in value, which can cause cashflow problems.

Is a Leveraged Loan Right for You?

You should only consider a leveraged loan if your investor profile is more or less as follows:

  • You're considering this strategy given your high tolerance for risk, which is reflected in your investor profile.
  • You're comfortable with a portfolio with no fixed-income content.
  • You can borrow money and afford the payments (interest and capital).
  • You could survive if the investment were completely wiped out. 

Don't change your investor profile just for the interest deductions. If gains are possible, so are losses, even over a ten-year period. Saving systematically, which allows you to enter the market gradually, is often more reliable and less risky.

The decision to invest using a leveraged loan should not be made lightly. If necessary, seek the advice of more than one financial advisor to make sure that you are comfortable with the level of risk involved. 

This text is intended exclusively to provide general information on financial security at retirement. This information may not be appropriate to the reader who wishes to obtain particular information on one of the treated subjects and cannot be a guarantee for results. It is up to the reader to make pertinent expert advice requests. This information capsule does not bind partner providers of these information.

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