June 8, 2007, 2:32 am

The Opportunity Cost of Paying Interest over an Investment Loan

by: The Financial Blogger    Category: Leveraging Strategies
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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:

Years

5

10

15

20

Investments with loan

$141,570.88

$200,423.14

$283,740.79

$401,694.34

Net Amount

$41,570.88

$100,423.14

$283,740.79

$301,694.34

Investment

without loan

$21,718.96

$52,815.91

$97,340.16

$161,089.47

Gap

$19,851.92

$47,607.23

$86,400.63

$140,604.86

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!

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Comments

Cash flow risk is also not an issue if you “capitalize” the interest. ie. use the heloc to pay for itself.

Sorry to nitpick, but you must account for the taxes that must be paid. In the above example, after five years capital gains must be paid on $41K for the leveraged investor and only on $3,700 for the investment without loan. The gap will be more like $11,000.

The point is not that leverage is not rewarding. It is judging whether you can accept the risks that come with it. What good is a strategy if you are going to panic and sell when markets are going in the wrong direction.

In the above example, a 30% fall in the markets will wipe you out after 5 years. You’ve paid all that interest over 5 years and have nothing to show for it. It is hard enough taking market risks, it is unwise to counsel taking on even more risk with leverage.

You can take risks in other ways than leverage – you can invest your entire portfolio in small cap value stocks or invest in penny stocks on the Venture exchange or even buy lottery tickets. We instinctively recognize the risks in above strategies. Why is it that when leverage is recommended, there is no mention of the risks?

by: The Financial Blogger | June 8th, 2007 (6:26 am)

MDJ, I prefer to leave all investment gains into my portfolio as compounding interest makes miracle. However, once you have built a good portfolio (after 10 years maybe), it is definitely a good idea to use part of your investment return to pay off the investment loan. Then, no cash flow is required and your are making money by doing nothing. Life is great !

CC, you are right about the tax implication. You are really good at pinpointing problem in calculation, second nature I guess J I’ll work something’s up during the weekend. Thx for the extra work 😉
I don’t consider huge drop in the market as you should not leverage to invest massively into small caps or penny stocks unless you are really rich and can afford to lose it all. If you buy index fund for example and wait 20 years, chances are you are going to average more than 7% base on stock markets’ history.

FB: I’ll admit that leveraging (moderately) to invest in a broadly diversified portfolio of low-cost funds is less risky than investing in small cap value stocks without leverage. It also allows you to tailor the risk level. Still, I hope investors are realizing that they are taking more risk and are sure that they are comfortable with it.

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