The Financial Blogger recently suggested that if you take out an investment loan, the compounding of the investments mitigate the risk of a rapid rise in interest rates:
Let’s take a 100K investment loan at prime for example. With an expected return of 7.2%, your investment will double after 10 years. Therefore, you will still be paying $6,000 of interest but you will make $14,400 in investment income. Compounding interest make your investment grow over time while you will always pay the interest on 100K.
Would you imagine the interest rate goes more than 14% in 10 years? It is possible. However, you need to remember that the interest paid on an investment loan is 100% tax deductible. Therefore, if your marginal tax rate is 40%, you end up paying 8.4% in real cost of borrowing.
I’ve heard the same argument (you pay simple interest on your loan, but your investments are compounding) as one of the benefits of the Smith Manoeuvre. However, a closer examination shows that a key detail is left out: there is an opportunity cost to the regular interest payments made on the loan. In other words, if you did not leverage to invest, you’d have an extra $3,600 ($6,000 in interest costs less a tax deduction at an assumed 40% marginal rate) in your pocket every year. If you invest it in equities and earn the same 7.2%, at the end of 10 years, you would have an investment portfolio of $50,200. After 10 years, your investment will be earning 9.6% ($14,400 on a total investment of $150,200), not 14.4%.
What about your interest payments? After 10 years, you will still be paying $3,600 per year on the investment loan (assuming you are in the 40% tax bracket), but you’d also have to add an opportunity cost of $3,600 (7.2% of $50,200). Your total cost will therefore be $7,200.
You would be correct in pointing out that leverage still works because in the first year you earned $7,200 and spent $3,600 and after 10 years, you are earning $14,400 and spending $7,200. Unfortunately, the picture isn’t as rosy because inflation (say, at 3%) has been compounding too and the present value of the spread is only $5,350. Meanwhile, you shoulder all the risks of leveraged investing when you could have simply invested the interest payments and taken a less risky route to building a sizable portfolio.
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17 responses so far ↓
1 FourPillars // Jun 6, 2007 at 7:33 am
CC your example assumes no income from the investments which is valid if you are reinvesting the dividends.
The leveraged investing I’m doing involves using the dividends to help pay the interest cost. Currently I have 1 lot of BMO - the interest rebate covers 43% of the interest cost and the net (of tax) dividend covers 51% of the interest, leaving only 6% of the interest for me to cover (not 60% as in your example). My assumption is that as the dividends rise (I assume 5% / a), they will eventually cover and exceed my net interest cost so there won’t be any cost to myself and therefor e no opportunity cost lost.
At least that’s what my spreadsheet tells me
2 The Financial Blogger // Jun 6, 2007 at 7:35 am
CC,
I never thought of calculating the opportunity cost over the interest paid. Leveraging strategies still offer a positive spread but you are right, it is less than we might think. I’ll go back to my calculation table and think about that!
Thank you for bringing that up to me!
FB.
3 0xCC // Jun 6, 2007 at 8:32 am
FourPillars,
You do still have an opportunity cost. What would happen if you didn’t borrow to invest in your BMO? Would BMO say “Oh, Four Pillars doesn’t have any interest on an investment loan to pay so we don’t need to send them that dividend check.” ?
You are losing the opportunity to invest that dividend in something (even more BMO shares) instead of sinking it into the interest expenses you are incurring.
4 Phil S // Jun 6, 2007 at 8:41 am
Dividends are generally a lot less than the borrowing costs of the money and is only paid out once per business quarter. Many REIT distributions, on the other hand, are paid monthly and in some cases have more than 50% of it being classified as return of capital for tax purposes which would only be realized as a capital gain when the units are sold.
Personally, I have a Home Equity Line of Credit that I use for leveraged investing but I tend to use it more like a cash advance than just leaving the balance in place and working the interest rate spread. For example, my Line of Credit is currently almost fully paid off and it’s sitting there waiting for opportunities to arise in the stock market. If for example the stock market plummets this summer, then I will deploy the money to buy investments - but then start to pay it back with earned income from my salary, I’m not counting on the investments to pay back the leverage because most of the time my investment horizon is 3 to 5 yrs. In my past experience, some of these investments may not move at all for 3 yrs then suddenly jump 25% in the 4th yr or whatever. Very few investments in my experience are “straight-line” enough to be able to fund the interest on the Line of Credit.
5 FourPillars // Jun 6, 2007 at 8:56 am
oxCC - I disagree that the dividends represent an opportunity cost in my case. The only reason I decided to buy the stock was because most of the cost was covered by the tax rebate and the net dividend so to say that the dividend is an opportunity cost, doesn’t add up.
6 Enough Wealth // Jun 6, 2007 at 9:07 am
I’m too tired to work through your example, but gearing works well in practice. For example, have a go at this real world example based on my US stock portfolio which uses 100% borrowed funds:
Amount borrowed against my home equity: $100,000
Interest rate charged on the loan: 7.25%
Hence, interest cost of loan: $7,250 pa
Dividends from investment pa: 2.5%
Hence, dividend income: $2,500
Net tax-deductible interest cost: $4,750
After-tax cost of interest: $2,850
BUT I pay this interest out of capital gains on the investment, not my own pocket, so there’s no real opportunity cost involved - My $100,000 investment has gone up 12% during the year, so I sell it and make $12,000 capital gain, which is taxed concessionally at 20%. I net an after tax gain of $9,600. After paying the after-tax interest cost of #2,850 out of this gain I still have $6,750 of after tax income more than I would have if I hadn’t borrowed to invest. And I never contributed a cent.
Of course there is risk involved, which means some years I’ll make a smaller gain, or a loss. In those years there would be an opportunity cost on the money I have to pay out to service the loan from my own pocket. But, in other years the gain will be higher than 12% and the return on that excess gain would offset the opportunity cost of the interest in the sub-average ROI years.
Overall, you’d only borrow to invest if the expected average return on the investment was higher than the interest cost. In which case overall there’s no opportunity cost to be calculated on the interest paid as it’s covered by the capital gains that wouldn’t have existed if you hadn’t borrowed to invest.
If interest rates increase above the expected ROI you’d simply liquidate the investment and not borrow to invest.
At the end of the day, the real risk you bear is that the actual ROI during your holding period isn’t what you expected, and is less than the interest cost. In that case you make a loss.
Regards
http://enoughwealth.com
7 0xCC // Jun 6, 2007 at 9:49 am
FP, what I am saying is the fact that you are using the dividends to pay your interest means you have lost the opportunity to use those dividends for something else. Therefore there is an opportunity cost in the interest you are paying (in addition to the actual cost of the interest), not the dividends you are getting.
I think your point is that you wouldn’t have borrowed to invest in BMO if there wasn’t a dividend paid which is reasonable but that doesn’t eliminate your opportunity cost. I guess it just lowers your opportunity cost, you could be using that 6% you are paying out of your pocket to invest directly in BMO and be able to keep all the dividends (albeit much lower since you would only own a fraction of what you own using leverage).
8 FourPillars // Jun 6, 2007 at 10:25 am
ocXX - I’ll have to think about this a bit since I’m getting confused about whether I’m creating opportunity or throwing it away
One point though - the “6% you are paying out of pocket” is mostly not out of my pocket - it will be covered by the divs & tax rebate so if I didn’t do the leveraging - there would be next to no $$ to invest directly in BMO.
I’ll be posting some detailed analysis in a couple of weeks of my leveraged strategy which will include all my thoughts about it.
9 Canadian Capitalist // Jun 6, 2007 at 10:45 am
4P: Dividends are part of the total return of 7.2%. If you use dividends to cover the interest payments, you have to subtract the dividend yield from the return assumption. I’ll grant you that banks have been yielding 3% and posting total return in the double digits for the past 15 years, but I don’t think it is sustainable. So, you can either consider dividends as being reinvested (which would imply accounting for an opportunity cost) or you can consider dividends as reducing your current interest obligations (which would reduce future total return assumptions).
oxCC: I agree with you that whether or not dividends are paid and to what purposes those dividends are used are immaterial to the analysis. The 7.2% assumption is total returns including dividends.
Phil: I follow the same strategy whenever I think there is a huge bargain in the market. But then I pay down the investment loan out of future savings. This allows me to invest regularly and not try to time the market and take advantage of any good opportunities when they arise. But this happens very occasionally (like during the income trust massacre).
Enough Wealth: I agree totally with your analysis. However, the post I referred to assumed that the investment is made for 10 years, not one. You clearly understand that leveraging is no free lunch: you take more risk to earn a higher reward. Others seem to want to show that it is not so.
10 Confused // Jun 6, 2007 at 12:26 pm
CC, I’m pretty new to investing so please bear my ignorance.
We are comparing leveraged investing to non-leveraged normal investing. Isn’t it the case that if I had the money to invest I wouldn’t need leveraged investing? If it is a choice between not investing at all and leveraged investing wouldn’t it be better to leverage invest?
Perhaps what we are discussing is whether to invest more using leveraged investing or less using tradition investing. However, if it is the case that we know leveraged investing is better than not investing we can extrapolate that investing more using leveraging is better than investing less?
BTW: great blog and excellent topic, especially now that interest rates may be on the rise
11 Canadian Capitalist // Jun 6, 2007 at 1:03 pm
Confused: The background to the post is another post by FB in which he showed that interest rate risk diminishes over time when you leverage and invest in equities.
What I am trying to show (I don’t blame you, the math makes my head hurt too) is that the advantage is not as large as you might think and to make a valid comparison you should account for the interest payments made on the leveraged loan.
I am not denying for a minute that leveraged investing probably will give you a better return. But you get the extra return by taking extra risk. To borrow a metaphor from the book “When Genius Failed”, leveraging is a bit like picking up quarters in front of a steam roller. You should be extremely careful or you’ll get flattened.
12 The Financial Blogger // Jun 6, 2007 at 5:33 pm
CC,
I was thinking about your example today and I would like to know why are you considering inflation as your loan payment will be affected by it anyway right ?
Cheers,
FB.
13 Canadian Capitalist // Jun 6, 2007 at 5:53 pm
FB: Not sure I understand your question. The only way to compare money in the first year with the tenth year is to take inflation into account. Inflation affects loan payments positively (in real terms it is decreasing) and opportunity cost negatively (part of the 7.2% return is inflation).
14 The Financial Blogger // Jun 6, 2007 at 7:02 pm
Correct me if I’m wrong (sometimes I think maths were created to increase Tylenol’s sale) both your monthly payment and your investment return is being reduced by the same 3% inflation rate, nominal dollar value comparaison approach should be as good as actual dollar value. In the end, the gap between the interest rate paid and the investment return will be represented for both situations.
Thx.
FB.
15 Canadian Capitalist // Jun 6, 2007 at 8:05 pm
FB: You are right. Both investment returns and interest payments are being reduced by the inflation rate as well. You can compare nominal dollars in the same year (in fact, in the post all the 10th year calculations are in nominal dollars) but to compare 1st and 10th year dollars, you have to account for inflation.
16 FinancialJungle.com // Jun 6, 2007 at 9:34 pm
FourPillars - I’ve written a piece on leveraging to buy BMO:
financialjungle.com/2007/05/13/investing/bmo-a-poster-child-for-cash-flow-leverging/
I agree that the dividends should be considered as opportunity costs, but whatever.
Reality is, leveraging to buy BMO is still much safer than buying stocks that don’t pay dividends, because dividends are more reliable than capital gains. Additionally, when you strip away the dividends and measure share prices alone, I’m not convinced that the average dividend-less stock can still outperform BMO.
Having said that, I’m not comfortable with over-leveraging. 15% is the most I can tolerate. I’m currently sitting on 17% cash.
17 The Financial Blogger » The Opportunity Cost of Paying Interest over an Investment Loan // Jun 8, 2007 at 6:32 am
[...] interest can compensate of the risk of interest. Canadian Capitalist wrote another post related to Leverage and Interest Rate Risk. He was explaining that we must consider the opportunity cost of paying interest when we contract [...]
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