This is where your finance takes place

In order to understand the full potential of an investment loan, there is nothing like some calculations. I will demonstrate what will happen if you invest on a monthly basis or if you use the same monthly cash flow to pay interest only on an investment loan.

Here are the rules: The amount of the investment loan is $50,000, interest rate is 6.5%. The monthly payment is therefore $270.83. Your investment plan is over 20 years and you think you can get an average of 8% out of the market. Finally, your marginal tax rate is 40%.

By investing $270,83 on a monthly basis over 20 years at 8%, you will get $159,524.40. During this period of time, your invested capital is $64,999.20$ for a net gain of $94,525.20. It is not so bad for the same amount as a car payment!

However, if you contracting a $50K loan over the same period with the same yield you will get… $233,047.86. By taking off the 50K debt, you will realize a pure profit of $183K. You are already making 22K more than without the leveraging strategy. But there is more!

In fact, all the interest paid on the investment loan is tax deductible. Therefore, you would receive almost 26K (so 40% of $64,999.20) in tax refund over the next twenty years. You are still not convinced, yet another little surprise.

In addition to the additional profit of 22K and the tax refund of 26K, there is one last thing I need to mention. In fact, if you calculate the growth of 8% on 159K ($12,761) and the growth on 233K ($18,643), you will notice that you will be making $5,881 more with the leverage loan than by investing by yourself. This difference will keep on increasing over time.

A lot of numbers, a lot of calculation but only one thing to remember: with the same growth, you would make more with a leverage loan. Although everything is related to the interest charged and the expected yield, you should end up with more money in your pockets. That all it matters, isn’t it?

So you are looking at your neighbour, brother-in-law and colleague making money with the stock market and you are wondering how the hell can they do it? They are not making more than you do. However, they have 50K, 100K even 250K invested somewhere. There is a good chance that they are using leveraging and that they have a debt related to this big chunk of money sitting on their investment portfolio statement. Should you do it? Does it worth it for you? Not necessarily.

In fact, leveraging strategies such as the investment loan and the Smith Manoeuvre were built for wealthy individual. Before contracting a $100,000 debt, you must know that sooner or later, you will have to reimburse this loan. Regardless where your investments stand at, the bank will give you a call to pay it back. This is why most institutions are looking at lending half of their clients’ net worth.

However, if you have a net worth of $50,000 and you have extra monthly cash flow, nothing should stop you to apply for a $25,000 investment loan. I personally think that everybody who has a little bit of investment knowledge should leverage. Even if it’s only with $10,000, it is still a good start. This money will grow as you gain confidence and experience on the stock market.

Most leverage strategy loans are interest only. The main reason being that in most countries, interest paid on these types of loan are tax deductible. Therefore, the monthly payment is minimal. For example, a $25,000 at 7% will cost $146 per months, so not even a car payment.

Besides the minimum net worth required and the monthly payment, there is another crucial aspect related to the leveraging strategies. Can you sleep at night knowing that you owe $25,000 but your investments worth $15,000? The market risk is one of the most important aspects of this strategy. You also have to consider the psychological factor related to the fluctuation. Everybody is smiling the market jumped 10% in one months. Unfortunately, it is not always the case.

Before starting a Smith Manoeuvre, contracting an investment loan or using a line of credit to invest, you must establish an investment plan and complete your investor’s profile with a financial professional. With your investment profile, your financial planner will be able to determine with you can benefit from any leveraging strategies.

Recently, I spoke about leveraging strategies and their basics. Even if there are huge advantages of using leveraging strategies to create wealth, there are also important risks to take in consideration. However, these risks can be controlled.

Timing risk

The timing risk is crucial when you are planning to withdraw your investment. As you have a debt related to your assets, you must remain conservative in your investments before you cash in your investment. Imagine people that had all their assets in the techno funds and planned to retired in 2002. They must be still working right now! If you use an investment loan, a line of credit or the Smith Manoeuvre, you must determine your investment horizon. When you approach from the date of withdrawal, you can move your portfolio to fixed income products or high dividend companies stock. Therefore, you will be assured to retire in time.

Interest risk

In the case of most leveraging strategies, the interest rate charged on the loan will be variable. This is your way to get closer to prime rate and then reduce your interest cost. However, no economists will guarantee that prime rate won’t go back to 10% in five years from now. If it’s ever the case, your investment would have to give more than 10% in order for you to make money. Aiming 10% yield means volatility and therefore big fluctuation. I don’t know about you, but I wouldn’t feel comfortable to loose 15% of my portfolio in a span of one month. This could be the case if you want big returns. In addition to that, you would still owe money to the bank…

Market risk

The market risk is inherent for any investments. Nobody can predict how the market will go in the future. Except Warren Buffet! Even then, he won’t let you know;-) As you are playing with others’ people money, I suggest you have a well diversified portfolio. Concentrating all you assets in one industry or a small group of companies could be very profitable. Yet it could also lead to catastrophe. Aim 6 to 8% and pay 4 to 6% of interest. You will make money on the long run.

Liquidity risk

Another risk related to leveraging strategies is the liquidity risk. Depending on your type of investments, you might not be able to cash in your funds at anytime. Some mutual funds will have close end fees if their not hold for a certain period of time. Therefore, you must be careful in your investment product selection and build your portfolio according you your investment horizon.

Most of these risks can be controlled or reduced by the help of a financial consultant, banker or financial planner. Once again, I suggest to meet with more than one and to choose one that is familiar with the leveraging concept. With a good plan, you’ll end up with more money in your pockets!

Making money without having money. Is it possible? Yes. Is it risky? It depends. According to some financial professionals, leveraging strategies are the best way to loose money. According to others, they are the best invention since the stock market. Who’s right? It depends ;-).

The problem with many people is that they think about their potential gain and the fact that they are “playing” with others people money. In fact, many of them don’t realize the risk involved in such financial planning. I’ll talk about which kind of risk is related to the leveraging strategies later on. For now, let’s concentrate on the technique itself.

Leveraging consist in borrowing others people money on invest in a project. Let’s pretend you have $50,000 to invest in a start-up. You know you can do little with that amount even though it is sufficient to start the company. Imagine now what you can do if you have $500,000 instead. The potential of the company is much bigger with such start-up funds.

Leveraging is thinking big. You can’t afford it? Borrow money from someone else! Leveraging strategies are based on the fact that you can borrow money at a lower cost than your potential return. In other words, it’s like borrowing $200,000, paying back $10,000 in interest charges while you are making $50,000 out of your investment. Therefore, you cash in a net profit of $40,000. All of this without having to spend a penny as the cash down was borrowed and the interest paid among the profit. This is why we are talking about “playing” with others people money.

Over the years, financial institutions made custom leveraging products. They are now financing the purchase of assets that they can take as collateral. These securities can be mutual funds, stocks, properties and other investment products. Banks will then provide enough funds to buy the assets and register a lien on it. Therefore, you can’t dispose of this asset without reimbursing the loan. On the other hand, you will benefit for the full usage of the assets and receive any generated income.

As long as you mare making more money than the cost of borrowing, leveraging strategies are seen as a powerful financial planning tool. However, several risks are linked to these investment methods. I’ll review them in the next post.