Over the past week, Iâ€™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. Letâ€™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%.
Iâ€™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 â€œFVâ€ (future value) and replicate the same calculation according to your personal situation. Please look at the chart below:
Investments with loan
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 wonâ€™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. Iâ€™m sure you could call less people and concentrate on your investments!
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