The Financial Blogger recently suggested that if you take out an investment loan, the compounding of the investments mitigate the risk of a rapid rise in interest rates:
Let’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.
I’ve heard the same argument (you pay simple interest on your loan, but your investments are compounding) as one of the benefits of the Smith Manoeuvre. However, a closer examination shows that a key detail is left out: there is an opportunity cost to the regular interest payments made on the loan. In other words, if you did not leverage to invest, you’d have an extra $3,600 ($6,000 in interest costs less a tax deduction at an assumed 40% marginal rate) in your pocket every year. If you invest it in equities and earn the same 7.2%, at the end of 10 years, you would have an investment portfolio of $50,200. After 10 years, your investment will be earning 9.6% ($14,400 on a total investment of $150,200), not 14.4%.
What about your interest payments? After 10 years, you will still be paying $3,600 per year on the investment loan (assuming you are in the 40% tax bracket), but you’d also have to add an opportunity cost of $3,600 (7.2% of $50,200). Your total cost will therefore be $7,200.
You would be correct in pointing out that leverage still works because in the first year you earned $7,200 and spent $3,600 and after 10 years, you are earning $14,400 and spending $7,200. Unfortunately, the picture isn’t as rosy because inflation (say, at 3%) has been compounding too and the present value of the spread is only $5,350. Meanwhile, you shoulder all the risks of leveraged investing when you could have simply invested the interest payments and taken a less risky route to building a sizable portfolio.
