You may have heard or read that a leveraged loan can be useful to create your investment portfolio. Early on in your career, getting such a loan could be easier than waiting to have enough of your own money saved up to build your equity. Is it a good strategy for you? Let’s take a closer look.
1 – What is a leveraged loan?
It’s an investment strategy that involves borrowing to invest, usually in non-registered investments (at your personal level or within your corporation). The loan makes it possible for you to invest more than if you were only using your own savings.
- This strategy adds value when the after-tax return is greater than the cost of borrowing (loan interest rate).
- It’s riskier than a traditional investment so your risk tolerance must be very high and you must understand what these risks are.
Did you know that… if the strategy works, the rate of return is amplified.
If it doesn’t, is also magnified, as is the risk involved in the strategy.
2 – How does it work?
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Leveraged loan vs conventional savings |
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When the outcome is positive |
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Amount invested in securities |
Annual rate of interest on loan |
Annual interest payments on loan |
After-tax g |
After-tax gain or loss from leveraged loan |
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$100,000 (leveraged loan) |
5% |
$5,000 |
$7,000 |
+$2,000 |
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$5,000 (conventional savings) |
N/A |
N/A |
$350 |
N/A |
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When the outcome is negative |
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Amount invested in securities |
Annual rate of interest on loan |
Annual interest payments on loan |
After-tax growth (0%) generated by non-registered investments |
After-tax gain or loss from leveraged loan |
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$100,000 (leveraged loan) |
5% |
$5,000 |
$0 |
-$5,000 |
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$5,000 (conventional savings) |
N/A |
N/A |
$0 |
N/A |
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3 – What are the best features of this strategy?
Deductible interest
- At the federal level – If you invest the borrowed funds in non-registered investments, the interest is tax deductible against income for the applicable year. Although the interest is not deductible when the borrowed funds are invested in a registered savings account, t
- In Québec – The amount of deductible investment expenses is limited to the amount of investment income[1] earned during the tax year. If you don’t deduct your investment expenses in a given year, they may be carried back up to three years or forward indefinitely. This provincial rule applies only to individuals, not corporations[2].
Taxation of different types of investment income
- To determine whether this strategy is profitable for you, you have to consider the tax payable on the various types of income and gains generated by your investments.
Did you know that… when using a leveraged loan, it’s generally recommended to hold equity securities that generate significant dividends as this increases the likelihood of deducting interest on your provincial tax return and optimizes the overall tax efficiency of the strategy.
4 – Which pitfalls should you avoid?
- Psychological pressure – Don’t sell you investments when they decrease in value: sell securities when they achieve a good return and use the realized gains to purchase more stable securities to reduce your exposure to losses.
- Loss from fixed income securities – Their rate of return is generally lower than the borrowing rate, so they should be avoided.
- Riskier products – They are potentially more profitable, but highly volatile and they may lose value over long periods.
- Tax changes – Over time, the deductibility of the interest paid could be changed or cancelled.
- Loan conditions – If your investment loses value, you may have to repay all or a portion of your loan, which could cause you a liquidity problem.
5 – Can you deal with the risk involved?
Answer these questions honestly:
- How much risk can I handle and still feel comfortable? Will the stress keep me awake at night?
- Will I feel compelled to check my investments daily, or can I trust that time is on my side?
You could go forward if the following statements apply to your situation:
- According to my investor profile, I have a high-risk tolerance.
- I understand there are no fixed income securities in my portfolio and therefore my investments could be more volatile.
- I will have no problem repaying my leveraged loan (capital and interest), whatever happens.
- My financial stability would be unaffected by a sudden drop in the value of my investments.
Remember time is key. The money you invest should stay invested for a long period (at least 5 to 10 years).
So, should I get a leveraged loan or not?
Implementing a leverage strategy is a decision that you should not take lightly. Before considering it, first maximize your tax shelters[LL1.1] (FHSA, RRSP, TFSA, RESP). Talk to your Wealth Management Advisor and your tax professional to understand the risks and determine if this is right for you[M
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[1] Includes grossed up dividends from taxable Canadian corporations, interest income, the taxable portion of capital gains not otherwise exempt and other less common types of investment income.
[2] Corporations may deduct interest expenses regardless of investment income.
