Q

: I am 52 years old and my house is mostly paid off, so I have a lot of equity in it. I’m wondering if it makes sense to use that equity for borrowing and investing. I have

registered retirement savings plans

(RRSPs) and I max them out every year.

— Grahame

FP Answers

: You’re talking about leveraging, or borrowing money to invest. People borrow to buy homes, vehicles, businesses and vacations, but when it comes to borrowing to invest, leveraging is taboo in some circles.

There is no question that leveraging is risky and not for everyone, but it is a worthy strategy for some people and situations. Rather than cover all the ins and outs of leveraging, I will debunk one common myth and then provide a few strategic uses of leveraging and the associated tax deductions.

A common myth about leveraging is that if you borrow at six per cent, you need to earn six per cent to break even. It sounds logical, but it is not true. You can earn less, sometimes far less than your borrowing rate, and still come out ahead.

Financial educator Talbot Stevens did the legwork on this in the 1990s, when he suggested three reasons for a lower break-even return: tax deductions, preferred tax rates and tax deferrals. Let’s take them one at a time.

Tax deductions

: Generally, when you borrow money to invest, you can deduct the interest charges from your income. These tax deductions reduce your borrowing cost.

Preferred tax rates

: Equity investments are normally the investment of choice when leveraging, and the growth is in the form of dividends and capital gains, both of which are taxed less than interest income. An after-tax six per cent equity return is higher than an after-tax six per cent

guaranteed investment certificate

(GIC) return because the equity return is taxed less.

Tax deferrals

: Probably the biggest advantage of leveraged equity investing is the

capital gains

tax deferral. The bulk of your capital gain appreciation won’t be taxed and paid until you sell your investment. The tax deferral allows your investments to grow and compound over time while your loan interest payments remain constant.

Here is a simple example. Borrowing $100,000 at six per cent results in annual interest payments of $6,000 this year and $12,000 over two years (simple interest). Investing $100,000 at six per cent results in $106,000 at the end of year one and $112,360 at the end of year two (compound interest). The investment growth is ahead of the interest cost by $360 after two years.

Now, let’s find the break-even investment return needed for an investor with a 50 per cent marginal tax rate who borrows $100,000 at six per cent to invest and makes after-tax interest payments of $3,000 per year. This is compared to not borrowing to invest and simply investing $3,000 per year. The results (shown in the accompanying table) are after a 10-year period, after tax and loan repayment.

With no leveraging and earning zero per cent after 10 years, you will have $30,000 by investing $3,000 per year for 10 years. With a $100,000 leveraged investment earning zero per cent, your portfolio is worth zero once the loan is paid off, but you are down $30,000 because you paid $3,000 per year after tax to service the loan.

You only need to make 3.8 per cent on your leveraged investments to break even when borrowing at six per cent. If the money was invested for 20 years rather than 10 years, the breakeven would be 3.6 per cent. If your marginal tax rate was 30 per cent, your return would need to be 4.7 per cent. The higher your marginal tax rate, the lower your breakeven investment return.

Over the years, I have heard many different leveraging proposals, and I will share a couple of them: the RRSP/leverage combination and the

registered retirement income fund

(RRIF) meltdown.

It is common advice to make an RRSP contribution and use the tax refund to make a

tax-free savings account

(TFSA) contribution. An alternative using leverage is to make an RRSP contribution, then use the RRSP tax deduction to pay the interest on a leveraged investment loan and use the tax deduction on the leverage to make a TFSA contribution.

With a RRIF meltdown strategy, you withdraw taxable money from your RRIF and use that money to fund the interest, tax deductible, on a leveraged loan. The tax deduction offsets the tax on the RRIF withdrawal, and you start to build a non-registered investment portfolio. You can do the same with investments in a holding company.

You may be reading this and thinking that leveraging sounds good. On paper, leveraging always looks good. In real life, if you are not careful, it can be devastating if it goes wrong. If you are going to get involved in a leveraging strategy, anticipate that it will go wrong and have a backup plan.

  • Reader ‘way behind the eight ball’ on savings seeks help
  • What is the impact of two jobs on what I owe the CRA?

What could go wrong? Interest rates may go up, your income may stop or be reduced, you may get low investment returns, a big stock market drop may lead to panic selling when you still owe money on a bank loan, your loan may be called, etc.

There are risks to leveraging. That’s why the important question to always have the answer to is: What is your plan when the unexpected happens?

Allan Norman, M.Sc., CFP, CIM, provides fee-only certified financial planning services and insurance products through Atlantis Financial Inc. and provides investment advisory services through Aligned Capital Partners Inc. (ACPI). ACPI is regulated by the Canadian Investment Regulatory Organization. Allan can be reached at alnorman@atlantisfinancial.ca