[I was going to list all the reasons when you shouldn’t leverage and conclude with a maybe, but Thicken My Wallet beat me to it with a great post on this very topic. I have slightly reworked this post to avoid being redundant.]
Many of my fellow bloggers seem to think that leverage should be a part of every financial plan. While it may be a suitable choice for their own financial situation, I think it is unwise to suggest that everyone should get an investment loan.
It is easy to understand the logic behind leverage: you borrow money from your friendly banker at say 6% and invest it in equities and earn a greater return. As an added bonus, you also get to arbitrage the difference between tax treatment of interest payments (100% deductible against income) and capital gains (or dividends). Voila! You are making money on money you don’t have! What a great deal!
The problem with this logic is that for leverage to make a significant difference to your bottom line, you’ll have to borrow huge amounts of money. Let’s say that, on average, you expect to borrow at 3% and hope to earn 7% in the equity market. Your estimated average spread is 4%. To earn an extra $1,000 per year, you need to borrow and invest $25,000. Let’s say you heard the siren song of leveraging, borrowed and invested $25,000. The markets tumble 20% over the next year. Would you have the fortitude to stick with the plan, now that you are $8,600 in the hole? Only if you have lived through a bear market, you can answer that question..
I’ll admit that leverage would have worked splendidly in the past few years. The total returns from the TSX Composite for the past four years has been 26.7%, 14.5%, 24.1% and 17.3%. By borrowing at less than 6% (most of the time it was more like 4%), you would have made a nice profit in leveraging to invest. Now, ask yourself this question: If leveraging is such a no-brainer, why wasn’t it popular in 2002? Chasing recent returns is the surest route to investment ruin.
On a personal note, I have occasionally leveraged to invest in equities in the past. But I use leverage strictly as a liquidity tool when I don’t have enough cash to invest and I think there is an irresistible bargain in the market. I also try and pay down the investment loan within the next year and I have a strict rule of never leveraging more than 10% of the portfolio value. Even if everything goes wrong (investments tank, interest rates spike and our incomes plummet), I want to be assured that we would survive to fight another day with a mere financial flesh wound.