Enquiry about pros/cons of using lending products as long term investment
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Hi Guys,
Would like to understand the pros/cons of using lending products as a long term investment.
One Company AGF[ agf.com] talks about different lending products, one of which is borrowing to invest.
Not sure if these are reliable and really effective as a investment tool.
Would like opinion /advise of fellow CD's including FA's as well who are members.
Thanks
Location: Canada-Glorious and Free
Posted on: 25-09-06 16:26:14
Borrowing to invest is called leveraging. As you know there are certain loan to value (LTV)restrictions which vary depending on the asset you are investing in.
If you have say $ 200 and bought a mutual fund which gave you 10% return, you would have $ 220 at the end of the year. If you leveraged the $ 200 with a 50% LTV loan, you have $ 300 to invest. At the end of the year you would have $ 330. Return the loan and the intrest (say 5%), you would have $ 225 left. The effective interst for you is 12.5%.
If you do a number of scenarios, you'll notice the extra $ 5 (from $ 220 and $ 225) is the earnings from the loan (leveraged return), based on the difference between the return and the loan interest. So in the scenario above return rate is 10% the loan is 5% the difference is 5% on the loan amount of $ 100 equals $ 5.
The difference between the two interest rates is called the spread. The larger the spread the larger the leverage. The next most important factor is the LTV. The higher the LTV the higher the leveraged return.
Pros are simple. The return on your investment is enhanced. In the scenario above, the return for the $ 200 goes from the posted 10% to 12.5%.
Cons are just as enhanced. In a downswing, the losses from a leveraged investment are also enhanced. YOu can do the simple math required but in a situation where the return on the investment is -10% the leveraged return would be -12.5%.
bv
Quote:
Originally posted by Big Vee
Borrowing to invest is called leveraging. As you know there are certain loan to value (LTV)restrictions which vary depending on the asset you are investing in.
If you have say $ 200 and bought a mutual fund which gave you 10% return, you would have $ 220 at the end of the year. If you leveraged the $ 200 with a 50% LTV loan, you have $ 300 to invest. At the end of the year you would have $ 330. Return the loan and the interest (say 5%), you would have $ 225 left. The effective interest for you is 12.5%.
If you do a number of scenarios, you'll notice the extra $ 5 (from $ 220 and $ 225) is the earnings from the loan (leveraged return), based on the difference between the return and the loan interest. So in the scenario above return rate is 10% the loan is 5% the difference is 5% on the loan amount of $ 100 equals $ 5.
The difference between the two interest rates is called the spread. The larger the spread the larger the leverage. The next most important factor is the LTV. The higher the LTV the higher the leveraged return.
Pros are simple. The return on your investment is enhanced. In the scenario above, the return for the $ 200 goes from the posted 10% to 12.5%.
Cons are just as enhanced. In a downswing, the losses from a leveraged investment are also enhanced. You can do the simple math required but in a situation where the return on the investment is -10% the leveraged return would be -12.5%.
bv
Very well explained BV.
The leveraging is not for every one and certainly not for week hearted.
However, if some one stay invested in right investments for a longer period of time, say over 7-8 years or more, history tells us that the person would come out as a winner.
The leveraging is used as a 'wealth building' tool by the people who are in high income bracket. The reason being, they can write off the interest expenses they pay every month on the 'investment loan' and get tax refunds which ultimately increases the return they get on their investments.
I would like to show here just a very rough calculation to show the concept only without any prejudice and recommendation and without any responsibility on my part. Please also note that this is not to entice or induce any one to start leveraging without understanding the full concept from their personal financial planner and I am in no way responsible for posting this information here.
Let us Suppose a person who is in 40% (or 50% for high income earner) tax bracket and takes an investment loan (leveraging loan) of $50,000 at prime rate (presently 6%) and invests all $50,000 in NON RRSP account (good quality mutual funds based on his risk tolerance) for over 8 years and gets an average return of 8% per year his portfolio value would be approx. $94,600 plus. On the other hand his investment loan would still be at $50,000 as he would be paying monthly interest of $250 every month or a total of $24,000 in interest for the duration of loan.
As he is in 40% tax bracket, he would claim $3000 every year on his tax return as investment expenses as he has borrowed money to invest and would get every year a tax refund of $1200.
This refund would be invested in RRSP every year and it would get him another $480 extra every year which could be put towards paying down mortgage saving him further on interest and bringing down his mortgage balance. The money invested in RRSP portfolio would grow tax sheltered and be over approximately $15,000 with a very conservative return.
Now let us take the tax implication of the money he made in his portfolio. Let us also suppose that all the money he made (over $44,600)in his portfolio is capital gain. He would only have to pay taxes on 50% of the profit i.e. on $22,300 and at 40% tax bracket, he would be paying $8,920 in taxes. This means he increased his net worth by app over $54,000. In this $35,700 in NON RRSP portfolio and over $15,000 in RRSP and also reduced his mortgage amount by another app. $3500 or more. And all this by paying $250 per month for 8 years towards paying interest on leveraging loan.
Of course, this person could have also saved this $250 per month for 8 years at the same 8% interest and his total portfolio would have been app. $33,690. But as he earned an interest of $9690 and interest is 100% taxable, then based on his 40% tax bracket, he would have to pay approx.$3,875 in taxes reducing his total portfolio value to less than $30,000. The difference in the value of portfolios in both scenarios is his actual gain by doing leveraging.
Once again these are very rough calculations to show the concept only and are without any responsibility on my part. These calculations will change with the interest rates, personal tax brackets of every individual, risk tolerance and the time frame and mutual fund performances. If any body interested to know more about it then he/she can contact me and then we can discuss and find out if this would be in his/her interest or not.
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Pramod Chopra
Senior Mortgage Consultant
Mortgage Alliance Company of Canada
Hello
Excellant articles by Big Vee and Pramodji.
Pramodji, very well explained.
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Let's help each other to grow & prosper in Canada
Very nicely stated.
And it is not for weak hearted or for sleepy types.
Situations can change and returns may be different from those forecasted.
One may also have to hedge his/her investments.
And as pointed out by Big Vee, leveraging is a double edged weapon. Its acts both ways. As with fast car, you can reach there early, but if you crash, may God help you!
