Tuesday, 20 September 2011

Conservative Leverage

The concept of leveraging is much like a power tool one would use to build a house. Capable of both greatly enhancing a person's ability to build as well as damaging or harming you and what you worked so hard to build.

The benefits involved with using power tools far outweighs the risks, as long as the risks are properly managed. For example, you wouldn't operate a table-saw without safety glasses, or put your hands anywhere near the circular blade. With proper care and attention, power tools can drastically increase your productivity - whether you are building a birdhouse or your dream home!

Leveraging involves risk and return that are similar to power tools. It can magnify losses as effectively as it can magnify gains - and much like a power tool, you need to make sure that all your safety gear is in place BEFORE you start your leveraging.

There are many different ways to leverage. 1)Leveraging from your personal cash flow and 2)Leveraging from investment cash flow. Each type of leverage requires careful assessment to ensure that you don't expose yourself to more risk than you can financiallyand emotionally handle. 

Leveraging From Personal Cash Flow

This type of leverage involves simply borrowing to invest and then paying down the principle of the loan with interest or just paying the interest. Essentially, you borrow the amount you can afford to service and invest that lump sum of money. Then, rather than making regular investment deposits (say $100 a month for a fixed term), you borrow enough principle to create interest payments equal to your investment of $100 a month.

Each time the principle of leverage is discussed, the topic of risk must be reviewed. This article from Talbot Stevens, a renown Canadian authority on leveraging conservatively weighs in on the risks involved when using the principle of leveraging in your financial plan. Click here to view this brief overview.

Leveraging has significant growth benefits over RRSP's. Calculations demonstrate that over 20 years, a leveraged investment of $2,000 a year can more than double the same simple un-leveraged RRSP contributions yielding a benefit worth $165,000. Read more here.

Here are some key points to keep in mind as you asses your use of leveraging:

  • Be conservative (with cash flow, equity, and emotions)
  • Eliminate the risk of a cash/margin call
  • Invest for the long term
  • Prefer fixed/conservative investments to mitigate market risk
  • Diversify your investment (funds, bonds, land, etc.)
  • Most of all, Use a trusted advisor to help you understand the benefits and risks, to show you the best tools and to help you implement and stick to your plan

Leveraging From Investment Cash Flow

Leveraging from investment cash flow involves borrowing to invest and paying the interest expense from a portion of the cash flow that the investment yields. Generally, the interest rate earned on the investment would be higher than the interest rate charged by the lender thus creating positive cash flow.

Sound scary? This strategy is more common that you may have thought. Take a look at this example that brings it into perspective - purchasing a rental property with a mortgage (also called leveraging). You would pay the mortgage and all other expenses for the property with the rent that was collected from the tenants. The ultimate goal would be to create positive cash flow - rental income would be higher than the expenses including the mortgage payment.

This is how most businesses work from day to day. In fact, this is so common, that the Federal Government has declared the interest paid on leveraged loans create a tax deduction. This is the Governments incentive for you and I to borrow money to create more jobs and to grow the economy.

It is important to note that leveraging from investment cash flow changes the landscape of this principle. When borrowing based on your personal cash flow, you assess what portion of your monthly income you will set aside to service that strategy. When you use investment cashflow to service your leverage, part of the risk is increased while other parts are decreased.

First, lets talk about the risks that increase. When you leverage from cash flow, an assessment is done to determine how much you can afford to pay each month. You are prepared to spend that amount on your investment - the most you will ever pay is what you determined you can afford (provided your interest rate remains the relatively same). When planning to pay interest costs with income from an investment, there can be a tendency to take on much larger interest cost. This can do wonders for your portfolio, provided the investment continues to produce the income that is expected. Investments like some bonds, income funds and dividend producing funds are some of the tools that can be used to accomplish this end. To mitigate this risk, make sure you can afford to carry your leverage out of personal cash flow should your investment income cease. 

Now, a risk that decreases - this is your emotional risk. When your investment is set up to pay your interest charges as they are incurred, you don't have to worry each month about how you will cover that payment. This can make executing this principle easy and maintenance free when set up properly thus reducing the "perception" of risk. 

No matter what method you choose when weighing your options, be sure to call us to get a full understanding of the risks and rewards associated with leveraging. From directing you to lenders that won't make margin calls to finding stable asset backed investments that yield steady returns, we are here to help you.

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