This is where your finance takes place

Over the past week, I’ve had an interesting debate with the Canadian Capitalist about compounding interest VS the risk of interest. In this previous post, I was explaining how the power of compounding interest can compensate of the risk of interest. Canadian Capitalist wrote another post related to Leverage and Interest Rate Risk. He was explaining that we must consider the opportunity cost of paying interest when we contract an investment loan. The leverage strategy still works; however, the benefit is a little less than we might think.

I decided to pursue my calculation to see what the real outcome is off leveraging strategies. Let’s take the same example than in the previous post. 100K leverage loan at 6% interest rate. Yield is 7,2% and marginal tax rate at 40%. I use 40% as most people are close to this bracket. Leveraging strategies offer better return and are less risky in term of cash flow for people making higher income. We also assume that any income derived from the investment loan stays within the investment portfolio and no withdrawals are processed.

With the investment loan, you are required to make monthly payment in order to cover the interest. Therefore, a payment of $500 is taken from your bank account every month. As you already know, this charge of interest is tax deductible. At the end of the fiscal year, you will receive 40% back from the government (your marginal tax rate). So your real cost of borrowing is $3,600 a year or $300 a month. We will calculate the growth related to the investment compared to the growth you would get by investing $300 a month at the same expected return, 7,2%.

I’ll spare the big calculation chart and give you the result after 5, 10, 15 and 20 years. I use Excel to process my calculation as It is easy and user friendly. Therefore, you can use the formula “FV” (future value) and replicate the same calculation according to your personal situation. Please look at the chart below:

As you can see, the gap still exists even after considering the opportunity cost of paying interest on an investment loan. Not only that, but the gap increase even more over time. After 20 years, the difference is more than 140K. In addition to that, we have to keep in mind that I used an expected return really close to the interest rate.

There is always some risks involve while leveraging. However, they are not the same for everyone. In fact, if you have a high income, cash flow related risk won’t be an issue for you. You can afford a raise in the interest rate and the power of compounding interest will compensate to maintain the gap between your investment return and the interest paid on your investment loan.

I must admit that this chart seems very appealing; however, this is only one side of the coin. Nevertheless, I think that everybody should leverage according to their financial situation and need. After all, a $10,000 investment loan requires monthly payment of only $58,33 at 7%. This is about your cell phone bill. I’m sure you could call less people and concentrate on your investments!

I read a post on milliondollarjourney.com about Myths about leveraging into Equities. I decided to add more details regarding the interest risk.

Either we are talking about the Smith Manoeuvre or the RIF Meltdown Strategy; there are always individuals to outline the leveraging strategies’ risks. For example, they claim you have a huge interest risk as your loan is linked to a variable rate. The interest rate can fluctuate over time and cause surprises. Nonetheless, the power of compounding interest can eliminate this risk over time.

Let’s take a 100K investment loan at prime for example. With an expected return of 7,2%, your investment will double after 10 years. Therefore, you will still be paying $6,000 of interest but you will make $14,400 in investment income. Compounding interest make your investment grow over time while you will always pay the interest on 100K.

Would you imagine the interest rate goes more than 14% in 10 years? It is possible. However, you need to remember that the interest paid on an investment loan is 100% tax deductible. Therefore, if your marginal tax rate is 40%, you end up paying 8,4% in real cost of borrowing.

On the other hand, the earned income from your investment will be derived from capital gains, dividends and interest. If you select your investment properly, you should not be paying more than 15% to 20% on your investment income. Then, you would earn $11,520 if you are taxed at 20% while you are paying a net interest of $8,400 if the rate goes up at 14%. The interest rate would need to reach 19,2% in order to offset completely your investment income after taxes.

Let me tell you something, if prime rate goes up to 19% in ten years, you will have better concern than your possible investment loss. Economy would be in such a bad shape that nothing you could have done in the past could save you from the present situation.

It is obvious that you will not always make positive return years after years. However, if you have a well balanced portfolio, you could reach an average of 7%-8% without taking too much investment risk. In regards to the interest risk, I think I made it clear for everybody that it becomes a minor effect after ten years of investment.

First things first, I would like to thank Canadian Capitalist for hosting The Canadian Tour of Personal Financial Blog #3 earlier this week. This was definitely a great experience. For the tour, I posted an article about The RIF Meltdown Strategy explaining how to withdraw money from your RRSP without getting whipped by the taxes at the end of the year.

I received comments and emails about how profitable this technique could be for senior citizens who are not planning on investing their money in high risk portfolios. I then decided to create an example with real figures.

Here are the key points: You have 100K in RRSP and you would like to withdraw 7K for every year. You invested this money in a more conservative portfolio and your expected return is 5%. Your marginal tax rate is 35%. Therefore, you would pay $2,450 in taxes on a $7,000 withdrawal (7K*35%). After 10 years, you would have withdrew $70,000 and pay $24,500 in taxes. So your net income after taxes would be $45,500. Not bad.

I received comments and emails about how profitable this technique could be for senior citizens who are not planning on investing their money in high risk portfolios. I then decided to create an example with real figures.

Here are the key points: You have 100K in RRSP and you would like to withdraw 7K for every year. You invested this money in a more conservative portfolio and your expected return is 5%. Your marginal tax rate is 35%. Therefore, you would pay $2,450 in taxes on a $7,000 withdrawal (7K*35%). After 10 years, you would have withdrew $70,000 and pay $24,500 in taxes. So your net income after taxes would be $45,500. Not bad.

Now, take a 100K investment loan with an interest rate of 7% (right now, you can get 6% with most institutions) and pay interest only. Your 100K RRSP is still invested at 5% and you are withdrawing $7,000 again. At the end of the year, you will offset your 7K withdrawal with the 7K paid in interest on your investment loan. Then, what’s the point?

Let’s suppose that you are investing at 5% as well. However, your return should be composed by dividend and capital gain instead of interest income. The main reason why is because dividend is taxed around 8% (please see your provincial laws as it vary from 4% to 17%) and your capital gain should be half of your marginal tax rate, so 17,5%. In order to produce the chart above, I calculated a 13% average marginal tax rate at the end of each year. I also took in consideration that you would sell all you investment and reinvest every year to crystallize gains and calibrate your portfolio. I know it would not happen in the real life, but it makes tax calculation much easier for this example.

As you can see, after 10 years, you would get more than 62K and pay a total of $8,176 in taxes for a net amount of $54,173 after taxes. Therefore, after 10 years, even with a very conservative portfolio, you would still make almost 10K out of this strategy.

If you are wealthy enough, or do not have an aversion to risk, you can invest at 8% without jeopardizing your retirement. If you keep your RIF at 5% but you change your investment loan return at 8%, here’s what you will get after 10 years.

You would then get 215K worth of investment with a 100K debt and you would have paid a total of 15K in taxes. After taxes, you would get 100K in your pocket so more than twice if you would just have withdrawn your investment.

I think the numbers speak for themselves. The real question is not really if the technique works or not but more if you are comfortable with leveraging strategies because there is always the risk of negative return. No pain, no gain!

I’m always searching for ways to make money differently. I found another one for retired individuals. Many baby boomers have a ton of RRSP’s and plan on withdrawing their money to maintain their lifestyle. Do you know that when you are withdrawing funds from your RRSP, you are taxed on it? It is government’s pay back time and they can’t wait to get all this fresh money. But there is a way to get around this.

In fact, with the RIF meltdown strategy, you are able to slowly transfer your RRSP’s into non registered assets without paying much taxes. Whoa! This is getting tricky. I’ll outline the main points:

The first thing you need is an investment loan. Then again, leveraging strategies seems to be the key to make money differently. You don’t have enough cash flow to pay the monthly payment? It’s not a problem!

The interest charged on your investment loan is tax deductible. However, the money you are withdrawing from your RRSP account is taxable. Do you see where I’m going with all this? There you go: if you withdraw $6,000 a year and you pay interest of $6,000 on your investment loan, how much would you pay in tax? 0$.

But wait, where all my money go? I just make you lost 6K to give it to the bank… But your investment linked to your investment loan is growing at the same time. Then, if your investment went up by 8K the same year, you just transferred 8K from your RRSP.

However, the technique is not perfect. In fact, you will still have to pay taxes on your investment growth. However, your rate of taxation should be much lower than your regular marginal tax rate.

I’ll cover more of this strategy in the near future. For now, I strongly suggest that you read on taxation or that you get yourself a very good accountant. With all the different way to make money you can find here, you’ll need his help to fill in your tax report.

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Depending on the amount that you want to leverage and your financial situation, your bank might request a margin call to be added to the value of your investment. In order to cover their risks banks are setting up a minimum value to the investment linked to your debt.

As an example, if you are borrowing 150K secured by 150K of investment, your financial institution might not want to see the investment go below 90% of its value. Therefore, they will set a margin call at 90% or 135K.

If your investments ever drop below this limit, your bank will call you and ask for more money to pledge as collateral. This transaction has to be done the same day. If you don’t have enough to put back your investment over the margin call limit. The institution has the right to sell your investment at the market price and pay off the loan.

As the value of the investment is less than your debt, the rest of the debt will become unsecured and monthly instalments will be requested to pay it off completely.

Many people are scared by margin calls as it would become a painful experience if the investments drop suddenly. On the other hand, the bank is watching your portfolio for you and it should be seen as an alarm ring instead of a threat. You are better off loosing 10% and closing your loan than waking up two months later at minus 30%!

This matter should be discussed before you apply for any leveraging loan. Please note that margin calls don’t apply on The Smith Manoeuvre as the debt is secured by a property and the investments are free of liens.