Interest returns to leverage strategies

By Mark Noble | November 6, 2009 | Last updated on November 6, 2009
5 min read

The benefits of leveraged investing are fairly well recognized. You can easily magnify portfolio returns, and clients can deduct their interest payments at their marginal tax rate, assuming the leverage strategy not used in a registered account.

Leverage is not for everybody. It adds a whole new layer of risk to investing. If the investment doesn’t meet growth expectations, the client loses money in the investment plus pays the debt he or she owes the lender.

Despite the risks, there are advisors who believe that if you’re going to employ a leveraged investment strategy, right now offers some unique opportunities.

The current market environment offers an interesting opportunity for advisors. Interest rates are at historical lows, and while there is more risk in the equity markets in the short term, valuations don’t seem unreasonable from a long-term perspective.

Scott Plaskett, CFP, CEO of Toronto-based IRONSHIELD Financial Planning, says that for the right client, leverage strategies are attractive right now.

Generally speaking, Plaskett defines the right client as one with low debt, a stable cash flow and an understanding and tolerance of the risk associated with leverage.

Plaskett generally used 10 years as a minimum time horizon for a leverage strategy.

“The rates right now do offer an advantage for the long-term wealth accumulation. It doesn’t help on the tax deduction standpoint; I don’t put people in leverage strategies based on the sheer motivation of saving taxes. It has to be a good investment first,” Plaskett says. “Right now is a better time than it was a year and a half ago. Clients who had borrowed a year and a half ago would have gone through a challenging time. That’s why we want to ensure that we have the right client risk profile — not everybody can weather the storm.”

François Desjardins, president and CEO of B2B Trust, a leading investment loan provider in Canada, says he’s seeing an increase in client interest that does seem to be correlated to the current upswing in markets.

B2B launched a campaign in October, offering an interest rate of prime +1 on all of the 100% investment loans it offers, the equivalent of about 3.25%.

“Mutual fund sales suggest that customers want to get in the market point blank. That has been different from a few months ago. As things get back to normal, we’ll continue to see some return to the market,” Desjardins says.

Ted Rechtshaffen, CFP, CEO of TriDelta Financial, says the dividend yields on many stocks and corporate bonds are easily outpacing the interest rates clients would have to pay.

“For the right client, it’s a fantastic time to leverage: low interest rates, decent dividend yields and a rising market. It doesn’t mean it’s right for everyone. We don’t do leveraged investing where you’re focused for high growth and small cap stocks. Where we do leveraged investment is where the dividend yield is higher than the interest cost,” he says.

Rechtshaffen points out that he has employed this leverage strategy and it is working well for a client’s wife, who is a stay-at-home mom with no income.

“She is able to do a small writeoff on the interest costs. On dividend payouts, her tax rate is zero. After tax, she doesn’t get to write off as much on the interest side,” he explains. “Overall, if the market doesn’t move, based on the dividend yields she has, she’s still up 2.2% after tax. If the market goes up, it’s better, and if it goes down, at least she’s got that cushion there.”

Desjardins notes, most advisors are now opting for non-margin loans, which do cost extra.

“In the past, margin accounts were used. Now most investors are opting for a secured loan,” Desjardins says. “We offer the option of lending on margin, but I would say that more than 80% of our loans are now done without a margin option. We still offer the option. We give a discount of 25 basis points, but almost all of our accounts are all non-margin calls.”

Plaskett is adamant that his clients stay away from margin accounts.

“I prefer not to use mutual funds as collateral; when you use them as collateral, you’re subjecting them to a margin call. If the loan is done at the wrong time in the market, everything goes wrong at the same time (assets decrease in value and a margin is called). Margins greatly increase the potential volatility of the underlying assets,” he says.

Investment loans versus HELOC

Selecting the type of loan to use in leveraged investing can be tricky and depends on the client’s personal situation. Many advisors prefer home equity lines of credit (HELOC), because they unlock investment wealth from the client’s home.

“Home equity collateral is all we use,” Plaskett says. “If the client has paid off their mortgage, they’ve got all this equity tied in the home. I refer to that as dead equity because it’s not being utilized. For the right clients with a stable cash flow, we can use that to grow their investments.”

Rechtshaffen says he’s partial to home equity strategies as well.

“The investment loans are fine. We do one of two things. We usually do a home equity line of credit, because it’s the easiest to close out a position. You basically say, either we have a lot of gains or we have losses,” he says. “Sometimes we’ll do a loan strategy structured as a mortgage. A client will come in with $250,000 and say they want to eliminate the interest rate risk component of the strategy. We’ll structure it as a mortgage with as high an amortization as you can, so you’re not paying a lot of principal, and we can lock in a rate at about 4% right now.”

Desjardins points out that using a HELOC or home equity strategy for investing can be messy. Clients have to track what portion of the loan proceeds have been used for investment purposes.

“The most important thing about investment loans versus HELOCs is the fact that you can really separate out the interest deductibility,” he says. “Advisors have found it’s much simpler to really take out the investment portion and put in a loan with an interest statement. You don’t have to worry in discussions with your accountants whether it was for investments or not.”

In addition, with an investment loan, clients have more flexibility in how they use their home equity.

“If you want to use your house collateral, it’s now frozen up. It’s now guaranteeing investments and can’t be used for other expenses,” he says.


Mark Noble