May 6, 2014, 5:40 am

Another Look at Leveraging

by: The Financial Blogger    Category: Smith Manoeuvre
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A long time ago on this blog, I wrote several posts about the Smith Manœuvre. This was a very popular concept a few years ago. More precisely, before 2008.

 

The Smith Manoeuvre was born in Western Canada when several households decided to convert their mortgage debt into a tax-deductible debt. After all, if Americans have the right to deduct their interest on their mortgage, why couldn’t we? The Smith Manoeuvre allows that over time. If you are not familiar with this strategy, I recommend you read my articles here and there.

 

The problem with the Smith Manoeuvre is that it implies leveraging. Instead of paying down your mortgage, you keep borrowing money from your line of credit to invest in the stock market. This makes this part of your mortgage tax deductible. But you still have a debt outstanding. As long as the market goes up, everybody is a king with this strategy. In 2008, most people were crying in their basements.

 

Now that the dust has settled, interest rates are still low and will remain low for a while and the stock market keeps rising, this looks like the perfect time for leveraging again. Back in 2009, I had to stop my leveraging strategy. Not because I was afraid of the market, but because my financial situation didn’t allow me to borrow anymore.

 

The key point with any leveraging strategy is to be able to support the stress.

#1 Stress from market volatility.

#2 Stress from the outstanding debts.

 

There were lots of changes in my life in 2009 and I couldn’t support having additional debt on my mind. We had our second child two years earlier and now my wife was about to stop working. The fact our budget had become thinner was the main motive why we decided to stop leveraging.

 

Right now, my situation is improving, I’m getting ahead of my debt payments and can feel the moment when I will have extra cash each month. I will possibly get rid of all my consumer debts (besides my car loan and mortgage) by January 2015. At that point, I will have more money to handle.

 

I’ll be left with two options: pay down my mortgage and car loan faster, or invest this money. Or… I could restart my Smith Manoeuvre!

 

I know leveraging is risky, but someone who has been borrowing to invest over the past 10 years is smiling today. Net of fees, a growth mutual fund (75% in stocks / 25% in bonds) did about 6.50% annualized rate. The investor probably paid an average of 3.5% in interest rate over that period. This leaves 3% net of fees and interest annualized for the past 10 years without disbursing a single penny.

 

If an investor had borrowed 100K 10 years ago, they would show a net profit of $52K after ten years (before taxes). So 52K is being made while enduring the most important stock market crash right in the middle of your strategy. 52K is being made without you putting a single penny on the table, not even to pay for the interest. 52K is being made and you can keep on going as the compound interest will make the next 10 years even more interesting. Because in 20 years, the same 100K borrowed will be worth $352K. Net of interest, and after paying the 100K loan, there will be 182K left in your pocket (minus taxes).  So now we are talking about 182K in profit when you didn’t use one dollar from your pocket to invest.

 

As I just mentioned a few paragraphs before, leveraging is not made for the faint of heart. If you can’t keep up with a portfolio down by 20% and an outstanding debt of 100K, you are not made to leverage. But for those who can afford it, this strategy makes a lot of sense these days. I’m pretty sure some were able to make the 52K from 100K in just the past 4 years…

 

What do you think? Are you in for leveraging again?

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