To leverage or not

In the financial world, leveraging is a fancy word for “borrowing to invest”.

There are 3 common ways to do this: traditional loan, margin account and a whole life insurance policy.

A traditional loan is self-explanatory. It can be a line of credit (secured or not) or a low interest loan. Borrowing on a credit card at 25% interest to invest makes absolutely no sense.

A margin account is used to buy securities. The money is lent by a broker, and the securities are used as collateral. You can’t purchase mutual funds on margin. There are rules for doing this. The amount loaned depends on the value of the security.

If the value of the securities decreases and there is not enough money in your account, you will face a margin call. A margin call requires you to put money into your account. If you can’t do it, the broker can sell your securities. You may actually lose more than your initial investment.

A margin account allows you to buy more than using just your personal money. If the value of the securities increases, you can make a decent profit when selling them. Interest on margin account is also fairly low.

A whole life insurance has 2 components: the insurance and the investment account. The money in the investment account is tax-sheltered. The investment belongs to the policy owner, not the insurance company. It can be used as collateral for a loan, without withdrawing the funds.

The main consideration for leveraging is the cost of borrowing versus the return on investment. If your investments are not registered ones, you need to factor in the tax costs.

Canada Revenue Agency allows the deduction of interest paid on loans, if it meets all the following conditions:

• the loan was used to earn business or property income
• there is an obligation to pay the interest costs
• the interest costs must be paid or payable during the year
• the interest costs are reasonable

Interests paid on a loan for registered investments do not qualify.

Back to the original question, leveraging can be a strategy if:

• you have a medium to high risk tolerance. Leveraging magnifies both gains and losses. It is also hard to predict how markets will do.
• you have very little or no debt, or if you do, you also have strong cash flow or assets
• repeat: you have strong cash flow and/or assets. If the investment doesn’t perform as expected, you are still responsible for paying off the loan.
• you have a rather long-term investing objective.
• you are disciplined to pay the loan back if you sell your investments for a profit

Leveraging is actually not suitable for most people. Be wary of financial advisors recommending this. Ask them how much more commission they will make by getting more of your -borrowed- money.