Many investors are unfamiliar with the leverage loan, and for good reason! Since it is a special investment strategy, you have to know all the ins and outs to use it properly. Unfortunately, leverage loans are often the subject of misleading promotions, aimed especially at young people who don’t really know how they work. So let’s take the mystery out of leverage loans!
What is a leverage loan?
It is an investment strategy that consists in borrowing a sum of money to invest, usually in non-registered investments. It is based on the principal that the return generated by the investment will be greater than the interest cost of the loan.
Who can benefit from it?
Before recommending a leverage loan, an advisor should first consider your risk tolerance since this strategy will amplify the results obtained: if the markets rise, the profits will be greater, but if they fall, the loss will be bigger.
Your advisor should also take into account your borrowing capacity and your current wealth. You may be able to borrow and afford the interest payments; however, in case of a loss of capital, your financial situation could be seriously jeopardized, as is often the case with young professionals, students or professionals starting their practice.
An example to illustrate
An investor borrows $100,000 at an interest rate of 3.7%. He must therefore be able to afford to pay $3,700 a year in interest.
- If the markets rise, everything is fine.
- If the markets fall, his financial situation must allow him to incur a capital loss of up to the amount borrowed, i. e. $100,000. That’s something to think about!
The following table will enable you to visualize the situation:
|Gain situation||Without leverage loan||With leverage loan of $100,000|
|% return on capital||8.0%||12.3%|
|Final result (from the original $100,000)||$108,000||$112,300|
|Loss situation||Without leverage loan||With leverage loan of $100,000|
|% return on capital||(20.0%)||(43.7%)|
|Final result (from the original $100,000)||$80,000||$56,300|
Is the interest deductible… or not?
For the interest on your loan to be deductible, the sums borrowed must go into investments that pay interest income or dividends. The interest is not deductible in the case of the purchase of shares of a company which, explicitly, does not intend to pay dividends. Even if the money invested in registered accounts such as an RRSP, a TFSA or an RESP produces income, the interest paid to invest in these accounts is not deductible. It may therefore seem preferable to invest the money in a non-registered account in order to benefit from the interest deductibility. However, the following table shows that it may still be advantageous to invest in a registered account.
|Return net of tax||5.00%||2.33%|
*Using a maximum rate of 53.31%
As you can see, a leverage loan has benefits and drawbacks that largely depend on the investor’s financial situation. At the beginning of a career, this strategy is much more perilous because of the risk tolerance and borrowing capacity of a young professional. The possibility of incurring substantial debt is a pitfall that you should discuss with your financial advisor. The risk is lower at other stages of your career, when your net worth is greater and when the capacity to absorb a loss has less serious repercussions on your financial future.
Want to learn more about a leverage loan? Talk about it with your advisor from the Financial, who can inform you about all the details of this strategy.
Benoit Chaurette, M. Fisc., Fin. Pl.
Manager, Professional Practice