Hey there, time traveller! This article was published 1/8/2014 (2641 days ago), so information in it may no longer be current.
Not all debt is bad debt. You've probably heard that before. After all, most people use leverage to their advantage with the largest purchase of their lives: a home.
And apparently, the message having a little red on the ledger can be beneficial is getting through to many Canadians -- at least the high-net-worth ones.
A recent survey by Investors Group found one in five Canadian families with more than $500,000 in investable assets carries a mortgage with an average size of $157,000, and 67 per cent of them have the investments on hand to pay off their mortgage in one fell swoop.
But they choose not to as part of an overall strategy.
"If we think back to our parents' generation, I grew up learning to stay away from debt or to pay it off as quickly as possible," said Peter Veselinovich, vice-president of banking and mortgage operations at Investors Group.
"What we've seen evolve over at least the last generation is an understanding that not all debt is bad."
The survey also found high-net-worth Canadians choose to carry mortgages for a variety of reasons, including having bought a home for their children or even parents, or the purchase of vacation or income properties.
In addition, 25 per cent of those surveyed don't have plans to be mortgage-free by retirement.
"The whole concept of extinguishing your debt before you retire and then beginning to save for retirement has been partly turned around. That's because of the lower interest rates for the last decade," Veselinovich said.
Among the options available to people -- because of low rates, rising home prices and financial institutions willingness to lend -- is borrowing against their home to invest.
The logic here is by taking advantage of interest rates, you can take out a mortgage, provided you have the cash flow to pay it, and invest the borrowed cash in relatively conservative investments such as blue-chip stocks.
"Now you have a situation where, because you've borrowed against the property, part of those interest costs is written off on your taxes," Veselinovich said.
"So that three per cent mortgage rate will look more like 1.7 per cent at the end of the day."
With the invested money earning three to five per cent on dividends, plus an average market returns of three to five per cent over the long term, "It becomes an attractive situation so one might argue that it's not necessary to pay down that debt because you're increasing your net wealth."
And some recent research does demonstrate the effectiveness of a leveraged investment strategy. In their book Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio, authors Ian Ayres and Barry Nalebuff argue borrowing to invest in your 20s -- doubling your initial investment -- and then slowly ramping down the risk with age, can increase returns by 60 per cent.
They even found the strategy actually reduced volatility over time compared to a non-leveraged one.
Given all these arguments for leverage, a house-rich investor may be pondering whether this strategy has merit.
Well, there's a big catch to all of these types of leveraged strategies -- especially ones that use your home, Veselinovich said.
"First you have to understand whether that strategy is right for you," he says. "It's dependent on age, expertise and the ability to service the debt without relying on income from the investment to service the debt."
That said; a strategy that involves borrowing to invest using a mortgage rather than a line of credit or a margin account (a loan against investments you already own) may be a better option in this regard because you're less likely to be forced to sell in a down market -- which amplifies your losses because you've borrowed the money in the first place.
"If you happen to fund that through a mortgage, and you have the ability to service that mortgage, the people that have provided that mortgage aren't concerned about what your investments have done," Veselinovich said.
"You ride the wave and get through it."
Yet this strategy is not for everyone, and there is concern individual investors are being advised to use it even though it's not a suitable fit for them, says Marian Passmore, director of policy at the Canadian Foundation for Advancement of Investor Rights -- or FAIR Canada.
FAIR has sounded the alarm on leveraged investing strategies in recent years, even submitting a position paper to the Canadian Securities Administrators, which represents all the provinces' securities commissions, warning about the potential misrepresentation of the upside of leverage by advisers.
"We recognized an emerging systemic problem that there appears to be too many unsuitable recommendations of leverage being given to clients," she says.
One of the changes FAIR wants to see regarding regulation is it's presumed from the get-go leverage is an improper investment strategy for clients of advisers.
"So the adviser should have to demonstrate that it is a suitable investment rather than it being the other way around where the client is supposed to determine suitability."
And FAIR has a point.
Cases dealing with the suitability of leveraging among mutual-fund investors are not uncommon. In fact, they're the second most frequent investigation undertaken by the Mutual Fund Dealers' Association of Canada (MFDA), which regulates mutual fund salesmen and saleswomen.
Last year, the MFDA investigated 49 cases, accounting for 12 per cent of all investigations nationally.
While it's not a massive number, the current securities rules regarding leveraged strategies and the client/adviser relationship can be vague.
Chris Besko, acting director of enforcement for the Manitoba Securities Commission, says many investors sign off on forms that acknowledge they know the risks associated with the strategy, so when they feel they've been misled by an adviser, it can be difficult to prove.
"There's not much recourse because if you know what the risk is going in, and if you're losing money, unfortunately, you may just have to live with that," he said.
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Generally, leveraged investment strategies aren't a good fit for most investors anyway, says certified financial planner Uri Kraut, a senior wealth adviser with Assiniboine Credit Union.
"If the loan was on a secondary property like a rental property or even a cottage I would say it is a reasonable strategy," he said, adding he is generally opposed to leveraged investment strategies. "But this is for individuals who have already paid off their primary residence and now have paid off a secondary residence--that's not going to be a very large market it good ole Winnipeg where we are blowing all our extra cash on Jets tickets."
Yet for those weighing the pros and cons of leveraged investment strategies, Veselinovich suggests they do a fairly simple litmus test.
"I call it the insomnia factor," he said. "If you're going to be up late at night worrying about it, then you shouldn't do it."
Debt by numbers
Not all interest is equal: An upside to leveraged investing is the interest can be deductible against income to reduce income taxes, but it's only deductible if there's a reasonable expectation of earning income from the investment. That means a stock, for example, must pay a dividend.
More ways than one to leverage: Investors considering borrowing to invest have a few different choices, provided they have the assets:
Margin: Investment accounts using margin generally let you borrow on a dollar-for-dollar basis to invest. For example, if you have $10,000 to invest, you could borrow another $10,000 to double down on your investment. The benefit is you don't have to borrow against another asset such as your home. The negative is if your investment falls in value, you could be subject to a margin call in which the brokerage requires you to pony up more money to rebuild the equity in your account. And if you don't, the brokerage could sell your investments to cover the lost money. For this reason, trades on margin usually aim to double a return over a short time frame. -- Investopedia
Home-equity lines of credit: If you have substantial equity in the home, you could borrow a portion of it to invest with the aim the return on the investment will outpace the interest cost on the loan. Some proponents of this strategy say the upside here is if you invest in dividend stocks, you can make a portion of the interest on your mortgage tax deductible. Another benefit is you only need to make the interest payments on the loan to maintain it. But because most lines of credit have floating rates, when interest rates rise, you could end up having to pay a lot more to maintain the loan. Additional problems such as job loss and illness can further impair your ability to pay the interest on the loan, compounding the problem. Possibly making matters worse is the investment falling in value to less than what you've paid for it, effectively doubling your losses. And if your home's value decreases at the same time, which tends to happen amid market turmoil, you could find your mortgage underwater, meaning even if you sell your home and your investments, you might still owe money. -- Borrowbetterwordpress.com
Home mortgage: This is generally a viable option only for individuals with property that's mortgage-free, and they are still working so they have ability to pay a new mortgage down while the borrowed cash is invested for the long term in dividend-paying stock. Besides the obvious downside of being at risk of doubling your losses in the market, you are also turning an asset that should be a source of stability into a potential source of stress, says Uri Kraut, a wealth planner with Assiniboine Credit Union.