Either we are talking about the Smith Manoeuvre or the RIF Meltdown Strategy; there are always individuals to outline the leveraging strategiesâ€™ 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.
Letâ€™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.
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