A guide to understanding leverage
Most Canadian homeowners have used leverage to reach their financial goals quicker, however many don’t even know it. Mortgages are one of the most common ways that individual investors use leverage, but if you don’t fully understand leverage and how to use it wisely, you might be missing out on some opportunities to increase your wealth.
In this article we’re going to cover the basics of leveraged investing, starting off with a simple definition.
What is leverage?
Simply put, leverage is the concept of borrowing funds and investing them to increase your portfolio returns. By using leverage, investors can increase their potential returns on investment, at the cost of additional risk.
Why would you want to borrow money when you have to pay interest on it? Well, the idea is if your investment returns are more than the interest you paid to borrow the money, you made a profit.
While it may be true that many people take on a mortgage without fully understanding leverage, when used effectively, a mortgage is not just a tool to help you afford a home, but can be a smart option for your financial future. Even if you have access to enough cash to purchase a home outright, savvy investors will opt to take on a mortgage because they expect to get greater returns on their capital than the cost of the loan. Why use your money to buy a home, when you can borrow it instead, leaving you free to invest your own money.
When and why to leverage often comes down to a very straightforward calculation. If the expected return on your capital is larger than the cost of borrowing, it’s often a good idea to leverage. That being said, this is a major oversimplification, and we still need to factor in the risk of your investments, so let’s go over some example scenarios and discuss the pros and cons of leveraged investing.
How to leverage real estate to grow your portfolio
A common way to access leverage is through real estate since it is typically the lowest cost of debt that the average investor has access to.
66.5% of Canadians own a home, and borrowing against the equity of your home is relatively cheap and simple compared to other forms of leverage that you may have access to. The reason for this is that in order to give you a competitive interest rate, the lender wants assurance that you’ll be able to pay back your loan. When it comes to other types of loans, the lender doesn’t have any guarantee you’re not going to borrow money and take it to the casino. When you borrow against the equity of your home however, the lender has assurance that even if you are unable to pay back your loan, you’ll still have an asset that can probably be sold to pay off the debt.
Investors can borrow against the equity of their property by refinancing their mortgage or taking out a Home Equity Line of Credit (HELOC).
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The benefits of using leverage
We’ve already covered the basics of how leverage works in your favour, but let’s go over some of the other benefits of utilizing leverage:
- Amplified returns: Any returns you make above your cost of borrowing is pure profit since you will be using the returns to both pay the cost of your loan, as well as your own pockets.
- Improved cashflow: If you invest in a high yield investment that is above your cost of borrowing, you can increase your cash flow. For example, if you invest $10,000 into a 9% yielding investment and pay 4% to borrow, each month you will generate $75 in income and owe $33.33 in interest, which is a net monthly profit of $41.67 to you. (ignoring tax).
- Broader investment opportunities: By having access to more funds, you may be able to access investment opportunities that would otherwise not be available to you. For example, some investments may require a minimum capital requirement that you wouldn’t have access to without borrowing.
- Taxable income reduction: If you are investing your funds in tax shelters like a TFSA, your returns are tax-free. However, the interest you use to invest can typically be used to reduce your taxable income, which means your effective cost of borrowing should be viewed after tax. For example, if you borrow at 5% and you pay a 40% tax rate, your after-tax cost of borrowing is 3% (5% x 60%). This is because interest is usually a deductible expense on your tax return. For example, real estate investors deduct the interest payments of their mortgage from their rental income.
The risks of using leverage
It’s a relatively simple calculation to determine if using leverage is the right move, IF you are dealing with a risk free investment. However, of course, the return of some investments are not guaranteed. If you’re investing in something like a GIC this isn’t an issue, but if you’re investing in a higher-risk asset it’s a different story.
The biggest risk of using leverage is that if your investment returns less than what it costs you to borrow the money, you will end up with a shortfall. If you’ve borrowed more than you can afford to pay for if your investment doesn’t pan out how you hoped, you could be in deep trouble.
Here are some of the risks of using leverage:
- Amplified losses: If your investments have a loss with leveraged returns, you will have to make up those losses with your equity. If your portfolio has large enough losses where your equity is not enough to cover it, you may have to liquidate other assets to cover the losses.
- Worse cash flow: Investing in an income producing portfolio to earn excess returns may not materialize as planned if those investments delay or cancel their distributions/dividends. You would then be stuck paying interest on what you borrowed without any income to offset it.
- Maturity risk: Depending on the terms of your loan, your lender may be able to force early repayment under certain circumstances. If this happens during a downturn, you may then be forced to sell assets at an inopportune time and recognize losses that you otherwise would have avoided if you weren’t forced to sell.
To mitigate these risks, it’s important to carefully plan your portfolio and financial situation, preferably with a financial advisor to make sure you aren’t over-leveraging and are doing proper risk management.
What is over-leveraging?
Over-leveraging refers to borrowing more money than you can afford to pay for. Of course, if your investments return what you expected this wouldn’t be an issue, but unless it is a completely risk free investment, there is always the possibility that you will need to make up for a shortfall.
An example of over-leveraging:
Let’s use an exaggerated example to illustrate the point: Imagine you are able to borrow $1 billion and your cost of borrowing is an even 0.00%. You’re offered an interest-free loan with a 30 year amortization. Now let’s say you decide to invest that into a market index fund. Unfortunately it’s October 2008, and your investment crashes 40% over the next year, netting you $400 million in losses. No worries, because it wasn’t your money and you borrowed it for free, right? Well, you still owe the lender $33.3 million towards the principal of the loan, and liquidating your investment will lock in those losses. This example illustrates how even an interest-free loan can end up with you in a very bad situation if you over-leverage.
On the other hand, If you were already a billionaire and could have paid off the annual $33 million while you waited for the market to recover in 2014 you wouldn’t have made a bad decision, so it’s important to take your own financial situation into account when determining what the right amount of leverage is for you.
An example of leverage in action:
For a great example of leverage in action check out this write-up by our Head of Mortgage Advisory, Ali Hussin: HELOCs in action: Maximizing cash flow.
For the purposes of this article, let’s go over a more likely situation.
Let’s imagine you’re nearing retirement with a paid-off home valued at $1,000,000. You talk to your mortgage advisor and find out you qualify for a HELOC of up to $800,000 at 4.50%.
You have enough liquid assets that you can afford to pay some of the interest payments, even if your investments are volatile in the short-term. You’ve heard of a mortgage investment fund that is advertising 9.00% returns with a minimum investment of $50,000. You decide to borrow $500,000 in the form of a HELOC, invest in the mortgage investment fund and net around $22,500 annually. You’ve now leveraged your home equity to generate passive income with minimal effort and low risk.
Of course, like we’ve already mentioned, whether or not to use leverage will depend heavily on your financial situation, your cost of borrowing, and what you plan to invest in. We recommend you discuss with a financial advisor before you make a big decision like taking out a loan to invest.
Our mortgage advisors are available to help you plan your mortgage strategy and see if you could be leveraging your home to grow your wealth.
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