July 31, 2007, 6:00 am

How Much Should You Leverage?

by: The Financial Blogger    Category: Leveraging Strategies
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Another great Carnival at Plonkee Money this week. Many fellow Canadian Bloggers are featured : Milliondollarjourney, Four Pillars and Financial Security Quest. Check it out! 

I had the idea of this post after a comment left on my blog from financialjungle.com on the article about The Double Dip strategy ( I know I was supposed to post the Double Dip Part2 a week ago, but I had problem posting the calculation chart. I should do it shortly). As you probably noticed by now, I usually use 100K for my calculation on hypothetical investment loan when debating about leverage strategies. Financial Jungle was suggesting that 100K might be too much for leverage. My answer to this is; it depends (haha! Speaking of a typical banker’s answer!). Seriously, I think that the question about leveraging is not if you should do it or not but how much should you leverage?

As I was explaining in my answer to Financial Jungle, there are two major factors to be considered when you are talking about leverage loan. The first one is your available cash flow. Investment loans are a good tool to apply the “pay yourself first” strategy. As you are actually contracting a real loan, you have no other choice but to make the minimum requested payment at the end of each month. As leveraging strategies are built on a long term investment horizon, you must ensure that you will be able to cover the monthly payment. You have to take in consideration your actual budget plus the possibility of interest rate going up. Hopefully, interest rate will not climb to the Everest Mount soon, but might sit at 7-8% for a while. Prime rate in Canada is already at 6,25% and might increase by another 25 points by the end of this year. Always make your projected calculation with a higher interest rate. You will have enough cash flow to pay the interest only and therefore, will not be forced to cash in your investment to pay it off during a bear market.Another trick is to already make an extra payment. If you can afford to pay $300 in a leverage strategy, take a loan that requires a minimum payment of $250. Therefore, you will cover the interest and pay a little part of the amount borrowed. Your deductible interest will not be affected too much (7% of $600 is $42) and it will give you the opportunity to build a safety net if interest rate goes up.The second factor to take in consideration is your net worth. Most financial planners, investment companies and other financial institutions will recommend borrowing up to half of your net worth. The calculation of your net worth is important as it could determine how much you should borrow. Please note that I do not recommend including car, furniture or other goods in your net worth calculation. Use your bank accounts, registered and non registered investment in addition to the market value of your property (stay conservative). The reason behind this rule is to determine if you can still live after seeing your investments going to the grave while you are still owing money. Even if it is unlikely to happen, there is always a possibility that markets fall into a big coma and never wake up. This possibility needs to be considered while you are doing your financial plan.In the end, leverage is for everybody. Using leverage for investments is accelerating the improvement of your financial situation. People will not convince me that you will lose money on the market over 20 years. If you really want to play safe, buy an index fund related to a specific market and wait 20 years. You will average about 7-8% and therefore, make money out of your leverage loan.

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Comments

Hello FB,

Good post. A few comments from some who has done this over ten years. Leverage only what you feel comfortable. Remember markets always correct. The index idea works well in a bull market, but …look at the the Japanese 225 index over 20 years…companies like toyota etc. has averaged about 1%!!

With index funds you can’t switch to another index fund with out capital gains…with corporate class funds you can.

Interest rates can stay low, but you can still have a bad market…look at the dow 1968 – 1982 about 2% over the 14 years! With reinvested dividends about 5.5%!!

Regards,

Brian Poncelet, CFP

Great Post FB,

Acouple of notes: Leverage what you feel comfortable with. Markets always have a habit of going down hard.

Index funds… the Globe and Mail had an interesting section on mutual funds that beat index funds in a down market and have out paced them over the last 7 plus years.

regards,

Brian Poncelet,CFP

Thanks for the link FB!

Mike

by: The Financial Blogger | July 31st, 2007 (7:50 pm)

Hi Brian,
Thank you for the precision on this topic. While I am not too big into index fund (I prefer trading myself), I thought it was an easy (and lazy :wink:) way of following the market. I must admit that your example from 1968 – 1982 makes me think a little bit further.

Cheers,
FB.

Hey FB

Here is another example (real estate). Water front on lake okanagan near Penticton (B.C) cost about $500,000 (with a house) in 2003, now that same water front is about $1,500,000 !! Yet for years in the 1990’s getting $200,000 was a struggle! (lots of Alberta money!)

Stocks real estate have a habit of staying flat for many years then jumping up in value! The problem is how many years will it remain flat? Many people give up! Who can blame them we want results now!

regards,

Brian