(February 2007) As the RRSP contribution deadline approaches, some clients might be considering options and strategies that include borrowing to invest. For some, the strategy works.
For the right client, one with a steady cash flow that allows regular interest and principal payments, assets made available through a loan, properly invested, can increase wealth — the loan assets can yield much larger returns over the long term than if the client waited to accumulate money to invest.
Even though a client is taking on a certain amount of risk when they invest, they also need to be comfortable with the prospect of carrying debt and the prospect of risking more than they currently have, especially if something as personal and important as their home is being leveraged to obtain a loan.
- The most important thing clients need to know about loans is that they will magnify the performance of their investment, for better and for worse. Leverage magnifies returns but it also magnifies losses. The math is relatively simple: A client who takes out a loan will have more money to invest in the market, which means their returns will be greater than if they didn’t take out a loan. The opposite is also true — if the investment tanks or returns don’t outpace the rate of interest, the investor is stuck with investment losses plus interest and principal on the loan.
- Taking out an investment loan is usually part of a long-term strategy. Over the long term, markets have historically outperformed rising inflation and interest rates.
- There are a range of investment loan options available. Generally the industry divides debt into two major categories: good debt, which has tax-deductible interest, and bad debt, which does not. Tax-deductible is considered good debt because if the client is going to take on debt, they might as well derive as much benefit as possible.
- RSP loans are a slight exception to the good debt, bad debt rule. The interest on an RSP loan is not tax-deductible, but clients in a higher income tax bracket will likely want to take advantage of tax deductions that come with higher contributions. Floating the RSP loan idea makes sense if your client wants to make an RSP contribution but doesn’t have the cash on hand. This works, provided there is a quick repayment plan in place.
- At the same time, some clients, those with a range of debt, may wait to pay off an RSP loan if the interest rates are significantly lower. That said, it is important to remember that the interest is not tax-deductible — the longer the debt is held, the more it negates any tax advantages related to the RSP contribution.
Long-term leverage loans
- Loans dealing with high-dollar amounts will be virtually impossible for a client to pay off over the short term. McPhaden says leverage loans, particularly those that involve mortgages, must be part of a long-term strategy. The advisor needs to have a strong understanding of the client’s financial capabilities, including a profound understanding of the client’s investment needs and saving abilities, in order to develop a manageable repayment plan that leaves very few variables that might hinder their ability to make scheduled repayments.
- Because investment loans tend to be geared towards clients who have little in the way of investments, business owners for example, there are a number of long-term lending strategies that leverage home equity for investing. These debt-conversion strategies usually require the owner to renegotiate their home mortgage, turning it into a line of credit that can be used to invest, making the interest on borrowed money tax-deductible. These strategies are complex, and require a great deal of explanation and research. Any advisor considering this option for their clients should probably consult someone who specializes in this kind of strategy before advising on it themselves.
Who should consider an investment loan?
- There is no hard and fast answer for this. Each client is different, as are their investment goals and their ability to assume risk. Bennett says an investment loan is a suitable option for clients who have their debt under control and a steady flow of income.
- Even if you believe you have clients who fit the financial profile, you need to be certain they understand the risks. Investment loans are not a good solution for emotional or impulsive investors. Apart from RSP loans, most investment loans require a long-term debt commitment.
- A client who is not confident with their long-term financial plan likely won’t follow it through — talk to your company or fund provider and do a thorough risk tolerance assessment with your client using tools you trust.
Who should NOT consider an investment loan:
- Clients with a history of bad debt management and questionable ability to manage extra debt in the future.
- Anyone uncomfortable assuming long-term debt.
- Clients who do not have a steady flow of income.
- Impatient or impulsive clients who are likely to change their long-term investment plan frequently.
Good sources for an investment loan:
- For RSP loans, look for manageable interest rates and pay schedules. Remind clients that longer terms negate tax-deduction value. If there are strings attached to a low-interest RSP loan, if clients must invest in products also provided by the lender for example, make sure the investments are right for their investment needs.
- Reduce risk by reducing unknowns. For long-term investment loans, look for those that do not have a margin call. A large part of successful debt management depends on developing a fee schedule that works with the client’s income flow. For most, a sudden call on the mortgage could send repayment schemes into a tailspin.