Borrowing From Peter to Invest in Paul: Does Borrowing Against Your Home To Invest Make Sense?
To quote an oft-repeated line from Hamlet, “Neither a borrower nor a lender be.” To many of us, like my grandfather, these are words to live by (particularly the bit about not borrowing). Traditional wisdom suggested saving until you could pay in cash and, if you had to borrow to buy something like a home, moving heaven and earth until you owned a clear title. As for me, I don’t see things as nearly that clear- cut. While I agree that saving for the future is a wonderful thing and that living beyond your means is the road to ruin, carrying debt isn’t necessarily as evil as some might suggest. I hope to show you at least a couple of exceptions to the general rule, after which I’ll turn the focus to leveraged investing using home equity. Then you can decide if it’s a good thing for you or merely for those receiving commissions. You’ll also see some suggestions that I hope will help tip the odds more firmly in your favour if this path appeals to you. Finally, although I’ll discuss some borrowing options in passing, I will leave a more detailed review of this subject to Russ Morrison, a mortgage-broker friend of mine who excels at this sort of thing.
Is Borrowing Bad?
If you live in Vancouver and have owned your home for a number of years, you are probably proof that leveraged investing can work when fate and fortune align. For most Vancouverites, the growth in home equity has been due mostly to climbing real estate markets rather than shorter amortization periods (or taking advantage of prepayment privileges written into many mortgages that allow you to make extra payments in order to get out of debt sooner). In other words, many homeowners have grown their nest eggs by taking out large mortgages and then watching the asset they purchased with this borrowed money appreciate far more than their interest costs. Even better, some of them also receive (rather than write) rent cheques each month if they have found someone to live in their basement or coach house; this can mean extra money for mortgage payments, perhaps the ability to finance buying a bigger home in the first place, and also the benefit of writing off some of their interest and expenses related to home ownership.
By the same token, if you borrowed to buy a rental property on the left coast ten years ago, you are also probably feeling pretty good about your retirement right now (even if you weren’t able to use the “got to live somewhere” or “rent is throwing money away” arguments to justify your decision to buy). In fact, many of my more successful clients, both past and present, have made their money through land ownership. Interestingly enough, this applies to many business owners too: although the business may have paid them a healthy income over the years, the real value, when it was time to close up shop, often lay in the shop itself rather than the other business assets.
Turning away from merely investing in land, borrowing itself is a common business strategy. In fact, some businesses get criticized for not borrowing enough. If they expect to make a 15% profit margin on borrowed loot, then borrowing at 6% to do so can make a big difference to the bottom line, whether it’s by taking out bank loans, writing bonds that are publicly traded, or even issuing preferred shares that raise money in exchange for paying out dividends (at a stated percentage or according to a set formula). Even the big banks do this sort of thing, and that seems to have worked out okay for them so far. Anyway, by this stage I hope you get my point: sometimes borrowing to invest can work out very well.
Putting words into numbers, let’s return to the basic homeowner example: if you put $100,000 down for a $500,000 home with a $400,000 mortgage at 3% five years ago and it’s worth $650,000 now, your return on your investment isn’t merely the 30% increase in value from $500,000 to $650,000 (minus your interest expenses and other costs of ownership). Instead, since you committed only $100,000 of your own cash to buy in, you’ve really made a $150,000 profit (less the expenses just discussed) on an investment of only
$100,000, which equates to a return of 150% before expenses. Thus, by borrowing $400,000 to buy, you have changed your return from 30% over five years to 150% (again, minus five years’ worth of interest). Even if this interest amounts to almost $50,000, you would probably still have about doubled your original investment of $100,000. Even better, if you are renting part of your home or claiming a portion as a home office, the true cost of borrowing can be significantly lower in light of the tax savings.
Is Borrowing Good?
If you’re assuming by this stage that I’m suggesting borrowing to invest is a no-brainer, not so fast. Consider the law of gravity: what goes up pretty often comes down (at least for a while). Even if you believe that certain assets always appreciate over the long-term, whether they actually go up during the particular period during which you’re in the market is another question entirely; if you need to sell at a time when the investment gods are otherwise engaged, you probably don’t really care if the stock, home or mutual fund you have to sell now goes through the roof five years later. Moreover, when talking about businesses and some investments, it’s very possible that some of them never go up in the first place — you might watch as your stock market darling begins a slow, inexorable slide toward oblivion, until either you jump ship or the company files for bankruptcy. Even talking about real estate, it’s also important to remember that there have been some pretty long slumps in the real estate market along the way, despite how much values have grown in places like Vancouver over the last decade or so. Yes, there are pundits who claim that the value of land in places such as Vancouver will never stay down for a prolonged period, for a variety of reasons, and perhaps history will prove them right. On the other hand, it is important to remember there were also a lot of talking heads who extolled the tech bubble before it burst so spectacularly; as well, few people foresaw the economic meltdown of 2008; and, finally, interest rates are at historically low levels, and that won’t always be the case.
Noting these cautionary words, I also suggest that you ask yourself whether you ultimately need to court the risk of losing someone else’s money in addition to your own in order to achieve your financial goals. If you are already on track to retire in style with a few extra dollars to spare, why run the risk of having to forgo your annual trips to the sunbelt during your golden years, just to earn some extra dollars that won’t really change your lifestyle anyway? Accordingly, I predict that few top-notch financial planners would ever sneer at a couple who were completely debt-free by retirement and with money in the bank to travel the world, even if that meant having to downsize, or unwind any leveraged investing scheme — no matter how lucrative it had been in the past or how much supposed sense it made going forward — to get there. What’s more, perhaps this conservative couple was now able to enjoy their retirement that much more since they didn’t have to sweat every market bounce; how much extra money is that worth?
Again, putting numbers into words, let’s also see some of the potential losses if things go wrong. Assume a client invested $100,000 of this own money, and $400,000 of his brokerage’s, for five years at 4% interest per annum, in an investment that produced exactly enough income to offset the borrowing costs net of taxes. If this total investment of $500,000 was worth $375,000 by the time he’d had enough, he hadn’t merely lost 25% — which represents where he would have been if he’d invested using entirely his own
money — but, since he’d originally invested $100,000 of his personal wealth, he would have lost 100% of his original investment plus the 25% on top of that. He would have had to come up with a further $25,000 from other sources after learning his original $100,000 stake was in the wind.
Strategies for Borrowing Against Your Home
For the rest of this article, I’m going to narrow my focus from leveraged investing in general to leveraging the equity in your home in particular. I will talk very briefly (for me) about some of the ways to borrow if you want to use your home as collateral. As mentioned, I will leave it to my friend, mortgage broker Russ Morrison, to expand and expound upon some of these options (and perhaps add a few of his own). Cutting to the chase:
- Property Tax Deferral Programs (PTDP): What’s this, you say? If you are in a province like B.C., there is a deal available to seniors (55+ in B.C. with 25% equity in their home) whereby the province will pay property tax to your municipality for you if you apply, get approved and pay the registration fee. You don’t have to repay this debt until you move or die. Until then, the province of B.C. charges simple interest at 2% less than their own borrowing costs. Right now, this means borrowing at 1% (the rate is adjusted to current conditions every six months) and knowing you aren’t paying interest on the interest. If this money is invested instead of put toward more expensive debt, e.g., credit card debt, car payments or even mortgage top-ups, your investment doesn’t have to work very hard to break even. If you are going to invest, consider using this money to fund a TFSA contribution for the tax savings, particularly since you probably can’t deduct the interest on the deferred tax anyway. Alternatively, using it to make RRSP contributions may also make sense, such as if you’re still working but expect to be in a lower tax bracket shortly.
- Reverse Mortgages: The biggest player in this game in Canada is CHIP. The basic premise is that they will lend you up to 40% of the equity in your home and not ask for their money back until you move or die. This allows you to access a lot more cash right away than the PTDP. If you do borrow to invest, the interest is tax-deductible if you pay it back each year rather than allowing it to compound with your outstanding debt. Speaking of interest, the charges are generally higher than a mortgage or secured line, but, from a cash flow perspective, you don’t have to worry about paying the interest costs as you go (if you can’t afford to do so), repaying principal prior to moving, or requalifying for the loan every few years. In the past, reverse mortgages were generally variable-rate only; however, some fixed-rate options, similar to traditional mortgages, are now available if you want to protect against rising interest costs eating into your equity more quickly than expected.
- Secured Lines of Credit (otherwise known as a “HLOC”): By using your home as collateral, you should be able to borrow money significantly less expensively than if you merely apply for a general line of credit that doesn’t give the bank priority over specified assets — a bonus to them when multiple creditors come calling. However, the bank may want both spouses to guarantee the loan, which could now mean exposing your partner’s assets to the bank — including a share of the house — whereas previously it was protected from their clutches. HLOCs are generally at a variable rate, and that can mean lower borrowing costs today but higher tomorrow if/when rates do eventually spike. If doing leveraged investing, you should also determine whether payments stretch some budgets and ultimately affect how much you decide to borrow. I also suggest learning about the circumstances under which the bank can call in the loan.
- Remortgaging or Taking Out a Second Mortgage: This is something that is used far more for investing in the borrower’s own business than in the stock market or other investment opportunities. A second mortgage will probably be at a higher rate than the first mortgage, which begs the question of whether there are other options that might work better. Likewise, remortgaging and blending deductible investment debt with non-deductible personal debt doesn’t always make the most tax sense. This is because you are able to deduct only a fixed portion of the interest payments related to the invested cash, and it doesn’t allow you to earmark how your payments are allocated between your deductible and non-deductible debt. For example, if only 15% of the debt is allocated toward investing, then you will always be able to deduct only 15% of the interest paid each year. Conversely, if you separate the personal and investment/business debt, you can earmark which repayment dollars get applied to each obligation. As a result, it usually makes sense to pay down the non-deductible debt first if it is at about the same interest rate, as the true cost of borrowing to invest is calculated after taking into account the tax deduction you’ll receive from doing so. For example, if borrowing at 4% in B.C. while in the highest tax bracket, your true cost of borrowing if the loan is 100% deductible takes into account that you’ll get 45.8% of this back at tax-time; that means you’re really only paying 2.17%. Finally, both of these options will probably require you to be paying back some of the principal as you go, which needs to be addressed when calculating your cash flow impact.
- All-in-One and Readvanceable Mortgages: While popular down under, this option is still relatively unexplored in the Great White North, although there are several providers at this point. The basic premise is that all of your debt is consolidated into a single uber-mortgage, resulting in a lower rate than what you’d pay if you’d kept all the loans separate. As well, the interest is simple rather than compound (i.e., you don’t pay interest on the interest), although, whether this saves you money compared to a traditional mortgage (assuming all else is equal, such as that you’re paying down the same amount each month) depends on the difference in rates. On the other hand, the all-in-one and readvanceable mortgages offer some extra features that are ideal for people using their home equity as collateral. First, you aren’t saddled with principal payments: you can go interest-only. Second, for some products, down the road you can reborrow any amounts you do pay toward principal, which gives you a lot more flexibility. Third, many products allow you to establish subaccounts so you can track different debts separately. In other words, you can have a separate subaccount that is dedicated entirely to a 100% deductible investment loan. Finally, when making payments on your debt, you can allocate where it gets applied. Since everything inside the account is charged interest at the same rate, there are some huge tax savings over the years if you apply all principal payments toward the non-deductible subaccounts first, and then pay interest-only on your investment loans (at least until all your non-deductible debt has been retired).When considering this option and investigating alternatives, I suggest looking at things other than merely interest rates, such as whether you can lock in rates for some or all of the debt (as with traditional fixed mortgages), whether you need to pay monthly fees, and whether it is possible investment loans. Since this last feature is one of the key tenets of the “Smith Manoeuvre,” which I will discuss shortly, you need to know if your bank or credit union’s proposed product will provide this feature.
The key variables when you’re looking at options are whether you want to borrow a little bit at a time or all at once and when you plan on investing and unwinding this strategy. Borrowing in a single fell swoop is definitely simpler in a variety of ways. First, it allows you to construct a diversified portfolio and gives you far more investment products from which to choose. Since some investments require a minimum contribution to get started, or are impractical, those of you without the desire or cash flow to invest in large chunks will probably look to products like mutual funds and segregated funds rather than individual stocks and bonds, at least until you’ve accumulated a critical mass. Of course, funds offer their own advantages as well, so this lack of choices might not be a drawback in your situation anyway.
To my mind, the greatest risks to investing all at once are market timing and perhaps taking on too much risk too soon. To the first point, investing with borrowed money already bumps up your risk level significantly. Accordingly, I suggest being extra cautious regarding when and how you invest. Rather than hoping you’ve picked the single best day to invest over the last decade, why not stagger your entry into the market over a number of months or years? Even if you now have the ability to borrow $100,000 against your home, this doesn’t necessarily mean that you should do so, or do so all at once. Although you might not make as much money as if you really could determine the best single day in history to invest, you are at least protecting against the possibility that you might have picked the worst possible day instead. Although slowly putting in the $100,000 in chunks of $10,000 at regular intervals may not match your enthusiasm or personality, I believe that protecting against losing borrowed money is worth forgoing some of the potential upside. Furthermore, although you may think you’re okay with leveraged investing, if you discover you don’t like the stress, it is a lot easier to unwind your holdings with minimal damage if you’ve only dipped your toes in the water instead of going “all in,” e.g., after your portfolio has gone off by 15%.
I also worry about when people choose leveraged investing, both in terms of whether it is too soon in their financial life or too late, e.g., for older investors who simply can’t afford to lose money. By the same token, there may come a time to either reduce leveraging or sell off completely, such as when you’ve already hit your financial goals, or when you’ve hit retirement with a limited cash flow and a continuing mortgage.
Returning to the basics of funding strategies, if you can’t afford large lump-sum payments or smaller, sizable contributions over a set period to fund your investment portfolio, then something like the Smith Manoeuvre might be up your alley. I won’t elaborate here, as there is lots of information available about this on the web or you can even buy his book. More currently, Gordon P. Johnson’s recent book entitled “Turn Your Mortgage into a Pension” offers his ideas on generating cash flow using your home equity. In 1,000 words or less, both authors use the following basic idea: when you make a mortgage payment, part of it is interest and part is principal. After each payment, you can turn around and borrow that part of the payment back and invest in the market. This is where a separate HLOC or readvanceable mortgage comes now with any luck you are invested in something that not only covers the interest portion of the new 100% deductible investment loan but also will either generate a lot more income along the way or hold out the promise of significant capital gains down the road.
With each mortgage payment, the process continues until, theoretically, you’ve paid down your original mortgage but now own an investment portfolio that, if things have gone well, is worth far more than what you owe; you will also have an investment loan. If your investments generate very significant cash flow or you sell some of them off along the way, you can use this extra cash toward your mortgage to speed up that happy day when your mortgage is completely tax-deductible. If your goal is to retire debt-free, you can then start directing the money formerly allocated to your mortgage toward your investment loan, or sell off all or some of your holdings to settle the score (or some of both.)
Gordon Johnson’s premise is slightly different. He focuses on investments that generate cash flow in excess of interest charges, and that react similarly to the interest rates on your investment loans when the rates change. In fact, he argues that his strategy isn’t leveraging in the first place but a savings plan, as the investors’ total debt never increases and they are really borrowing back their own money. Although I will let his book speak for itself, one of the investments he recommends is a Mortgage Investment Corporation (MIC). Investors invest in pooled mortgages that, in Canada at least, have paid out well in excess of carrying charges for a prolonged period. Essentially, he describes it as doing what the banks do: borrowing money at a lower rate than you can earn when you lend this same money to someone else. Accordingly, he is not particularly concerned about the amount of debt someone takes into retirement, in light of the extra cash flow the portfolio generates. In fact, he suggests that some of us may be better off carrying debt in perpetuity rather than having to liquidate high-yield investments to pay down deductible low-interest debt.
Of course, your decision doesn’t have to be one or the other; even if you do decide to take some of your investment debt with you into retirement, you always have the option of hedging your bets by paying down part of the loan and letting the other part ride.
To begin, if you want to write off your interest, you have to have a paper trail showing that the money was borrowed to earn investment or business income. I have highlighted “income,” as investing to produce only capital gains doesn’t count (although dividends are income and do generate deductible debt). For example, you wouldn’t be eligible for an immediate write-off if you bought empty land with a purpose of flipping it “as is” in a few years, but you would be able to write off a stock that paid a small dividend. In fact, the CRA has allowed investors to write off interest used to buy investments that currently don’t produce income if it can be argued that they might in the future. If in doubt, talk to your accountant.
As discussed earlier, if a loan is for a blend of deductible and non-deductible debt, you can deduct the percentage of loan interest you’ve paid equal to the percentage of the loan that was deductible in the first place. This ratio wouldn’t change going forward unless you borrow more money in the same account (which probably isn’t a good idea). Generally, you are better off having separate loans for deductible and non-deductible debt so you can focus on paying down the non-deductible debt sooner (assuming rates are comparable). Continuing the interest discussion, I want to provide a final reminder that only interest income actually paid can be deducted. In other words, you can’t claim a deduction for an expense you’ve never paid.
Finally, when picking suitable investments — and, if investing as a couple, determining whether it makes more sense for just one of them to implement this strategy — it is also important to remember how these investments will be taxed. Unless you invest in something that also produces 100% income or interest, each dollar of investment income will be taxed at a lower rate than the rate used to calculate your interest deduction. In other words, while 100% of interest income is taxable, only 50% of capital gains get taxed. If earning dividends, the dividend tax credit ultimately means you pay a lot less tax per dollar of dividend income than you deduct per dollar of interest. Even better, some investments also pay out some or all of their money each year as a tax-free return of capital, which can really tip the results in your favour.
By way of example, if Rich paid 3% interest to earn 3% in dividends, has a taxable income of $60,000 per year and lives on the Sunshine Coast, he can deduct 29.7% of his interest but gets taxed only 6.46% on the dividends. In other words, although at first glance it looks like his investment income and expenses cancel each other out, he’s still ahead of the game by about 0.7%. Over time, due to the magic of compounding, these little differences can eventually amount to big savings, especially when larger numbers are involved.
When deciding whether it makes sense for both or just one spouse to lever up depends on their respective income brackets, what types of investments they expect to own, and the distribution of assets between them, among other things. In the end, it really depends on each situation. Generally, if investing in something designed to produce mostly taxable income — such as an MIC — then they are probably better off investing through the lower-income earner in order to take advantage of his or her lower tax rates, even though that person would get a lower deduction on the interest charges. Conversely, if investing in something that produces deferred capital gains or return of capital, they are probably better off having the higher-income earner enter the market in order to maximize deductions, especially if the plan is for him or her to sell off after retirement when in a lower tax bracket. Again, a lot depends on the circumstances, so either do your own research or get expert advice before figuring out what makes the most sense for you.
As underscored by the comments in the last two paragraphs, it isn’t so much about how much an investment earns, but how much you are able to keep after deducting your interest charges and paying your taxes. Accordingly, when deciding if and how to invest, you may need to keep your calculator and tax-rate table handy.
Leveraged investing can also be about managing cash flow. Taking on investment loans can mean increasing how much you need to pay toward your total debt each year. If that applies to you and you’re already struggling to pay your bills and do the extras (such as fund your RRSPs and RESPs), then you will probably need investments that pay you as you go — and pay reasonably well. Not only can the investment income at least cover your increased borrowing expenses, perhaps it can also allow you to actually top up your RRSP this year and thus leverage your tax savings.
Finally, and in my view most important: since investing with other people’s money is a risky venture, it is important to take less investment risk than when investing your own cash for the long-term. To borrow from the Hippocratic Oath, I believe the first principle of investing with bank money should be “do no harm” or, at least, “minimize the chances of things blowing up entirely in your face.” I suggest picking investments designed to produce a reliable, stable and secure cash flow each month or quarter, and one that exceeds your carrying charges. If nothing else, even if your investments don’t grow in value, I would want to do what I could to ensure my investments pay for themselves along the way and, at worst, more or less break even over the long-term.
Along those lines, I suggest looking at investments like MICs, preferred shares with fixed redemption periods, convertible debentures, high quality bonds (rather than a bond fund) and income funds as the backbone of your leveraged investment portfolio. All of these products are designed to produce income and are less volatile than equities. I also suggest diversifying rather than just using a single investment vehicle such as an MIC. If you want to take more risk, consider doing so only with investment gains, such that, in the event that those investments don’t work out, you’re losing your own money rather than the bank’s. Even so, if you want to up your risk threshold after establishing your base, consider doing so only modestly, and continue to choose investments that pay their own borrowing costs along the way.
If investing in funds, I would suggest investigating corporate class mutual funds (again, preferably income funds) for their tax efficiency; however, although tax savings are nice, it is more important to focus on investment returns. That is, if your investment is likely to lose money anyway, or substantially underperform its peers, then tax savings probably won’t be much of an issue anyway.
There is a lot more I could say about leveraged investing, but once again I am running out of space and time. In the end, no matter how you sugarcoat it, leveraged investing using your home equity is taking a big risk (although you can take steps to mitigate that risk); whether it’s something you wish to undertake is up to you. If things work out in your favour, it can definitely be a game changer, but, if you’re ahead of the game in the first place, then perhaps a game changer is not what you need.
If this is something you’re interested in exploring further, here are a few tips I hope will cause you to name a child or household plant in my honour ten to fifteen years down the road:
- Be aware of interest-rate risk. Look at locking in part of your borrowing costs at some point, particularly when your total debt load remains uncomfortably high.
- Leveraged investing doesn’t have to be an all-or-nothing thing. Consider borrowing back only part of your principal payments rather than every last dollar. If a first-time homebuyer, I suggest waiting for at least three or four years in most cases before even considering getting started.
- Focus on income, safety and reliability as opposed to shooting for the moon. Pigs get fat; hogs get slaughtered.
- Get the advice of an independent mortgage broker. Picking the best borrowing product and terms can be as important as picking the right investments. Make sure you know the terms: when loans can be called in, prepayment privileges, monthly fees, and the ability to automatically borrow against the new equity you create in your home after each principal payment.
- Diversify your investments; focus on earning at least enough to pay your borrowing costs, and play it extra safe when investing exclusively with the bank’s money.
- Crunch the numbers in advance. Get an idea of your true cost of borrowing and the true rate of return on your proposed investments to get a better idea of your cash flow after the tax man has come and gone. Likewise, as Richard Vetter, a top notch financial advisor in Steveston, B.C. reminded me the other day, look at the fees you’re paying and previous returns net of fees, as high fees can turn potential good investments into bad ideas;
- Keep your total debt levels under control, and consider fully or partially deleveraging at retirement. Again, if you’re already on track to hit your goals, why risk things going sideways for a few extra dollars you don’t really need; and
- Sometimes the best answer is to just say, “no.” Leveraged investing is not for the faint of heart and it is always possible that it could blow up in your face, no matter how compelling the math. Perhaps you’re better off looking at other ways to fund your retirement.
As always, I welcome any comments or suggestions. Next time, as requested by some participants, I plan on starting a series of articles on estate planning summarizing some of the key points from my webinar of October, 2014, which can be accessed through Canadian Money Saver Magazine through the following link: http://www.canadianmoneysaver.ca/blog. Until then, may interest rates stay low and your investment returns reach stratospheric heights.
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