50. Leverage: Should you borrow money to invest?

Transcript:

Evan Neufeld: Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld. Today, Jordan is back with me and we are going to be talking about leverage - mostly the idea of borrowing to invest.

Jordan it's a bright sunny day here in Saskatoon. No better time than the present to be on the mic. Right?

Jordan Arndt: Absolutely, excited to be back. It's a nice day staring out the window, looking forward to it.

Evan Neufeld: Awesome. This is great. Thanks so much to everyone for listening as usual. The survey that we sent out, we actually got lots of responses to that. Thank you very much for that. We got lots of ideas for things that we can do on the podcast going forward and a lot of that is due to your feedback. So thanks again for that. So today's episode, we are talking about leverage. Jordan, what is leverage?

Jordan Arndt: Pretty simply, borrowing money to invest. So you might have seen that through maybe a mortgage, a home equity line of credit, investment loans, something called margin. But at its simplest definition, it's when you take someone else's money to buy something, an asset with cash that you don't have.

Evan Neufeld: Right. So you said with a mortgage, that is also a way to do that. So if your house is an asset, it retains its value and things like that. But average house price in Canada. What was it, $750,000 or something like that. Yeah, it's a lot. Those of you listening in Toronto and Vancouver, your situation is a lot different than us here in Saskatoon of course, we don't need to talk about the specifics of prices. But if you're doing a 5% down payment, that means that you're buying a house with a total cost that you're only contributing to 5% of. So in that case, you're taking a 20 to one leverage on that asset. So you used the, the power of the bank and the power of debt to acquire an asset worth way more than your cash could provide.  So when a lot of people think of leverage, they think, oh, it's like the people making dumb decisions or you know, someone that's super risky. It's like, no, if you have a mortgage, sorry you're using leverage. Yeah, exactly. So maybe let's jump ahead and talk why would someone actually consider using leverage and what's the point there?

Jordan Arndt: So quite simply like we talked about, mortgages, everyone's using them or lots of people are using them anyways. There's a quote in the Globe and Mail recently that today more and more people are getting HELOC’s than ever before. So HELOC is a home equity line of credit.  That's where you'd take equity that you've built up in your house and borrow against that for the purposes of whatever you want, really, I guess.

Evan Neufeld: Home renovations, going on a vacation.

Jordan Arndt: Use it however you please, but that is borrowed money. So there's an interest cost associated with that.  More and more people are accessing that, especially here in Canada where, let's stick with BC and Ontario. Home prices have probably appreciated quite significantly, especially if you've owned your home for a decent amount of time. You might have significant equity there built up that you're thinking about how do I tap into this to buy something else today?

Evan Neufeld: Right. And in most cases depends on your lender in a variety of other circumstances, but the idea with the HELOC is that your bank or your lender will provide up to 80% of the value of your home less your mortgage of course. So say you don't have a mortgage on a million dollar property. You could theoretically have a home equity line of credit for about $800,000.  I could come up with some ideas for things I could do with $800,000, any ideas Jordan?

Jordan Arndt: It'll have different terms than on your mortgage. You know, your mortgage perhaps has a fixed rate of interest for five years at a certain rate, your HELOC will be different. It might only have minimum interest payments but it'll probably be variable. It might be tied to the prime rates, which kind of brings us to our second point of why is this relevant today? Interest rates are going up quite rapidly. Both here and in the States, globally to some extent. So the interest rates were very low, which made the premise of specifically a HELOC, but any real leverage scenario, more attractive. And as interest rates come off very low to still quite historically low, but you know, high for our recent memory or higher anyways.  That makes your debt perhaps less affordable and just something else to consider.

Evan Neufeld: This dovetails back into our conversations about inflation and interest rates and how this will affect inflation. right? So if the cost of borrowing is going up, then it makes a lot of sense that it's like, oh my goodness if I could borrow at 2%, yeah, I'm going to Hawaii. Like that's free money. But if it's 7%, Ooh, it's a different story. It's a different conversation. So even though interest rates are going up. The Globe and Mail is reporting through TransUnion. It's a credit monitoring company. They're reporting that in the first three months of this year, 2022, the total amount owing on mortgages, loans, lines of credit and credit cards jumped 9.2% just in the first three months.  That's a lot. And Rob Carrick from the Globe and Mail, his comment on the stats, He said “Note the disconnect. Rates today are rising in a fast and furious way, which makes it a bad time to add to your debt”. Kind of stating the obvious there. It's like, okay, when debt is more expensive, you probably don't want to have it.

So this is why this conversation is relevant today. Another thing that I was thinking of there is along with the inflation side of things, when your cash flow is going to things like groceries and higher gas prices and things like that, your home is going to represent a greater percentage of your household wealth because you don't have the ability to save and invest into other things necessarily because your money's all going to consumables and things like that.

So, when homes are a greater percentage of your household wealth, many people start to look at alternatives to diversify their investments, and you might hear the term unlock equity in their homes. And like we said before, this is much more common in places like BC and Ontario, where those mortgage payments are huge, or if they're attainable at all.  And so people just don't have the ability to invest in other things, just because the cash flow isn't there. So this is going to be relevant for a long time, regardless of interest rates, as long as housing prices stay where they are. So let's talk about who is leverage appropriate for and I think the other side of that coin also says, what are the risks involved with leverage?  So we're going to do a bit of a yin and yang here on the appropriateness of leverage perhaps.

Jordan Arndt: And this is going to be more thinking about it from the perspective of borrowing money to invest perhaps in stocks or bonds or mutual funds or just general markets. Crypto, you know, we are reading an article here that a lot of people have borrowed as much as like 32% to have people invested in crypto have used a payday loan in the past. Like it's quite significant and kind of scary to be honest. So this'll be more kind of talking about borrowing money, maybe using your HELOC or something like that for the purpose of investing.

Evan Neufeld: Maybe let's back up and let's clarify that a little bit more then.  So the theory is you've got a home equity line of credit, so you have access to a hundred thousand dollars that's value of your home. Instead, what you do is you take that money out and you could go to a brokerage account or an advisor or a cryptocurrency exchange, God forbid here, and you buy something with that.

So that's dividend paying stocks or bonds or something along those lines. And the way that it works in the meantime is that you pay interest on the loan, but you hope for a gain on the investment, hopefully gain that offset the cost of the debt. That's kind of the power of leverage and maybe the mechanism here.  I hope you're hearing here on this podcast that leverage isn't necessarily good or bad for everybody. It can be appropriate, but in many cases it is not. So don't hear this as being an advocate for it necessarily. But let's maybe get into that. Like what are some situations where it could be appropriate here?

Jordan Arndt: Yes, definitely just want to have those considerations. So let's talk about first time investors.  I would think that we feel that leverage is not appropriate for people who are just getting started with investing. If you are newer to the investing space, you should really focus on understanding investing first.  What that means, how do I invest? Where do I invest? What do I do before exposing yourself to additional risk that comes with leverage?

Evan Neufeld: Is there risk with an investment Jordan? Yeah, of course.

Jordan Arndt: Yeah. Look where we are right now, the first six months of this year have not been great. So yeah, there's absolutely risk, which kind of brings us to the second point that leverage is more suitable if you have a longer time horizon.  In the short term, investments can be quite volatile and a bit more of a uncertainty of what might happen. So the shorter your time horizon is for needing that money, the less you should expose yourself to that leverage risk, you might just get the timing wrong.  However, as that time horizon gets longer and longer and longer historically, who's more likely that that would play out in your favor. So if you need the money, this isn't a get rich quick thing. If you need the money in the near term.

Evan Neufeld: Unfortunately, people do see it as it get rich quickly. That's why people are doing payday loans for crypto, right.

Jordan Arndt: It's not though, right. And it has the power to compound in the wrong direction for you where now you owe money on your HELOC or wherever you borrowed it from and the investment that the asset that backs it is had declined in value as well.

Evan Neufeld: Maybe let's jump in here and give a quick example of how it could work just with some dollars and cents. So let's talk about a total of an investment of a hundred thousand dollars. And in one circumstance you put in the hundred thousand yourself, there's no cost to doing that because you had the cash.  In the other hand you use leverage to obtain the one hundred thousand. So say you put in 50 and you borrow 50. So in both scenarios, they're still the same a hundred thousand. However, when you borrow, let's call it a borrowing cost of 5% on that. Then over time, let's call it a year. Your investment gain was 10%.

So in both cases you put in a hundred, however you obtained it and you had a final value of 110.  Pretty good deal, great year. With the person who used the leverage, that 5% borrowing cost means that they're $110,000 is then reduced by about 2,500 bucks. We're kind of using year end rounding math here, but close enough. So now the gain in that person's situation is only 7,500 bucks. But if you didn't use leverage, your gain is still 10,000. However, now let's look at your rate of return versus what you put in. So even though there was a cost to borrow the person who used leverage only put in 50,000 of their own, so that $7,500 net return on 50,000 is actually 15%.

Whereas the other person still just had the 10% that they got from the market. So you can see the power of this, even with a cost associated with it. Now let's see the opposite side of this when there's a loss, maybe Jordan, do you want to walk us through that one?

Jordan Arndt: So this is you know, think of leverage as that lever that has the ability to magnify.  So we just went through the good scenario where it was a positive outcome and it magnified the rate of return.

Evan Neufeld: I'm the positive one in the group here.

Jordan Arndt: Absolutely. I'll be the Debbie downer here. Let's go through the opposites here where it magnifies it on the downside. So same scenario, same investment amount, same, you know, one scenario you borrow half of it.  The other scenario, you put it all in. Same 5% borrowing cost. But this year, instead of the 10% gain, you had a 10% loss. So after you could factor in the loss and the borrowing cost, if you put in all the money, you lost $10,000. If you put in 50,000 with borrowing cost, you actually lost $12,500.

Evan Neufeld: Because you still had to pay interest on an investment that lost value.

Jordan Arndt: It doesn't matter whether that's going up or down, that interest cost is due and you hold that. So in a no leverage scenario, you're down 10%. That's it. The rate of return is, is negative 10%. However, in the leverage scenario, because you lost 12,500 on a $50,000 investment of your own capital, that actually comes out to a rate of return of negative 25% on that year.  So we can really see how that lever can work in both directions and in this case its working more on the downside to just to magnify those gains and losses.

Evan Neufeld: Absolutely and we're talking about a gain or loss here of 10%. If you recall our conversations on bear markets and crashes and things like that, the average intra year decline, even in years that end up positive throughout the year is 14%, it happens. These things are happening virtually every year.

Jordan Arndt: And that's where, you know, back to our point about your time horizon. If this is a three month play or whatever, some short term play to make money quickly. Yeah, just think about those couple simple examples and let's talk more about, I'll be the negative Nancy here, the loss side.  If you get that timing wrong in that three month period, it can have some pretty serious consequences for sure.

Evan Neufeld: So this kind of goes into our next point of who is leverage appropriate for or not appropriate for. It is not for risk averse investors and you know, one of our other partners here, Steven, we kind of laughed about a commenter we saw online during the the bull market over the last number of years. The guy said, I love risk. It's like, no you don't, you love return, right? No one loves risk, but that's the price of admission to participating in investment markets. Right? So for some people you can handle it from a financial standpoint.  So you could have saved a lot of money. You could have a defined benefit pension at work. You could have government benefits and all that kind of stuff. So your retirement comes around and said, okay, I didn't actually need to take on much risk because I've saved a ton of money and things like that. So that's called risk capacity. Its whether you have the ability to take on risk because you have backstops elsewhere.  Now there's risk attitude as well. It's a, what do you feel, when market goes down 10%. Do you still go out and see your friends and family or whatever, or do you lose sleep at night? You know, are you looking at your portfolio every day or are you spending time on your hobbies? Right? It's like, how do you actually feel and react to times in the market that are adverse outcomes than what you anticipated? So leverage is a situation where if you are a nervous person or someone that doesn't have a positive risk attitude, then leverage is not gonna be your friend here at all. Definitely not. Okay. So talking about that risk capacity there, this also relates to your debt picture as well. So if you are someone that has significant debts.  Pretty benign things like car payments or maybe unsecured lines of credit or whatever, that a lot of you listening might have adding an additional debt for the purpose of increasing your investment. Isn't something we can really stand behind here and recommend.  This is something that is going to compound the risks of carrying that debt. Especially in a situation where the vast majority of people that are borrowing to invest against their home, it's in a variable rate as well. And so the more debt you have, the more interest rate risk you expose yourself to.

Jordan Arndt: It kind of goes along the lines of considering your entire financial picture, where you need to have the cash flow for those interest payments on your borrowed money to invest.  So like we talked about your entire debt picture needs to be considered. You need to have the cash flow, liquidity, whatever else to be able to afford those interest payments and if you don't or consider the risk of rising interest rates as we've talked about consider how that will impact your ability to pay the bills.  On top of also now covering some additional interest costs.

Evan Neufeld: You mentioned paying the bills and that interest cost is a new bill that you would have to carry. So in most cases, you wouldn't have to pay principle on that. In some cases you will, but either way you've got a new cash flow item that you have to account for.  And for most people, if you're using leverage in retirement or on a fixed income that might be a red flag there, but if you're still in your accumulation years and thinking, this is for you, how stable is your employment? You know, that would be a pretty large concern for somebody if they are regularly unemployed or seasonally unemployed. You know, here in Saskatchewan, we have a lot of folks that if you work outdoors, you're probably not working outdoors in winter.  Anyways, it can make it really challenging to consider adding debt payments on risky assets with unstable employment. I hope you're getting the picture here that there's a lot of scenarios where this wouldn't be an advisable scenario for you.

Jordan Arndt: So I think the last thing that we'd just like to say about the risk is that leverage is very individualized. There's no rules of thumb here necessarily, or blanket statements that we could make.  You might have friends that are using leverage to invest. You might have family, you might have heard about it in the media. Maybe someone else's doing it with an advisor. Just be careful maybe and don't think that their situation applies to you. Go through your situation, figure out what makes sense and if you have the ability, capacity tolerance, all those sort of things to suitably explore leverage. And hopefully, you know, if you do work with an advisor, hopefully there's an advisor there that can help you through that process and understand it.

Evan Neufeld: Right. And just the general benefits of leverage are not going to be universal benefits to everybody. Like you said, it's very individualized, so yes, you could diversify into other assets and yes, you could buy low, you know, if you're buying things, it's great until it isn't right. And so just make sure it's appropriate for you. Not necessarily what you've read success stories or what someone on a YouTube ad is toting is something that you should be doing.

Jordan Arndt: Try and zoom out in the grand scheme of life in 2020 and 2021, things were going great. markets were going great. You know, there was meme stocks and game stop and things like that. You probably heard stories of people making a ton of money in a really short period of time.  Good point. I don't know about you Evan, but I'm not hearing those same stories in the last six months. That is sure quieted down. And so I think my point is just you might feel like you're missing out in those moments where you hear about someone else, but understand, you're hearing the exceptional stories and then you also don't hear about it when it goes the exact opposite way for them. And so just try not buy into the missing out philosophy. Kind of back to our conversation about just keep buying there, that book it's a long term strategy investing and this isn't a get rich overnight sort of thing at all.

Evan Neufeld: Okay. Lets finish off with one practical or a few practical items here. If you were hearing this and you're familiar with leverage and you're a high risk investor, you've got a good income, no debt, all that kind of stuff you say, Hey, maybe this is a good option. Stocks appear to be a little bit cheap right now or whatever and all the other boxes are ticked for me. What are some other things that you actually should be aware of if you are considering leverage? Well, the big one is the ability to deduct your interest and so the way that you have to do that if you are wanting to deduct your interest from your taxes, you have to invest that money in a non-registered account.

So to borrow to invest in a TFSA or borrow to invest in RRSP, that interest cost is not deductible. So when we gave our example before, I guess we didn't really do a tax deduction there. We could have done it, it gets a little bit complicated. But in any case, if you are wanting to deduct your interest, which is one of the common benefits that's toted for using leverage, it has to be in a non-registered account.  Now, what other things can you invest in? CRA's relatively clear on what assets you can buy, where the interest deductibility is actually applicable. And in their language, it says it has to be an income producing asset. So something that is explicitly capital gains only, it won't be applicable here. We're getting into the weeds a little bit more than I would really like necessarily, but things like dividend paying stocks, or even just public equities that could distribute income back to investors, those might be good options. I would highly recommend that you talk to your accountant or tax professional before you do this, just to make sure you're staying on the right side of the tax man.  So those are some things that you want to be aware of. You can borrow and invest in a TFSA and perhaps there is some merit to doing that. If you haven't already maxed out your TFSA, but just know that your interest won't be able to be deducted in such a situation.

Jordan Arndt: The other thing to be aware of is just the variable interest rates that might be tied with your borrowed money.  So as interest rates go up, as prime rate goes up, so does your borrowing costs. So just as you're thinking about it, consider, you know, probably perform some sensitivity analysis on the borrowing rate today and think about where interest rates seem to be going in the future to understand that your interest cost will change if it is a variable rate loan, Right.

Evan Neufeld: And even if you are using margin in a brokerage account, if you don't know what that means, don't worry about it. But if you do know what it means your brokerage is going to be changing their margin loans and their interest rates there. Even though it's not as obvious as something that's tied to prime, like with a home equity line of credit or something like that.  So just be aware of those things. So let's wrap this up here a little bit. What is leverage? It is borrowing. It is using someone else's money to finance the purchase of an asset. But in our case here, we were talking about borrowing money to invest. Leverage exists in a few other ways. We didn't really get into these other products, but you might have heard of leveraged ETFs, even trading options, things like that. Those are just plain and simple leverage. Getting an outsized return or outsized risk for the amount of money that you put in. It's a magnifying glass on your own money. Why is it relevant today? Well, people are going into more debt than ever before. Interest rates are going up and homes are becoming a much larger portion of people's wealth.

And so they're looking to alternatives like using leverage or borrowing to invest, to diversify and unlock the equity in their homes. Tons of risks involved with this, of course. It's not going to be appropriate for a first time investor or someone with a short time horizon or someone that wants to be a trader.  Someone who doesn't have a high risk profile, someone who has a whole lot of debt and if you have no capacity to actually lose some money here then leverage is not going to be a play for you. However, if you see yourself on the other side of the coin, maybe it is appropriate. And so you want to start asking yourself some questions there and incorporate a good accountant along with you to make sure that your interest is able to be deducted and you minimize some of the risks there as well. Did I miss anything, Jordan? I think that's a nice summary. Well, if you do have any questions about this as usual, you can reach out to us through the contact info in the show notes.  But thanks again for listening and we'll see you in a couple weeks. 

Thanks for listening to this episode of the Canadian Money Roadmap podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal and tax advisors before making changes to your financial plan. Evan Neufeld is a Certified Financial Planner and Registered Investment Fund advisor.  Mutual funds and ETFs are provided by Sterling Mutuals Inc.