Borrowing to Invest: Leveraging in .NET

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Borrowing to Invest: Leveraging
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Tim s Tip 62: Consider leverage to accelerate wealth creation and provide tax deductions
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What is this strategy called leveraging Simply put, it s borrowing money to invest And make no mistake, leveraging can offer some signi cant nancial bene ts The
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catch You ve got to do this prudently If you re not careful to follow the rules of prudent leveraging, you could be in for more harm than good In this tip I want to look at the rewards, risks, and rules of prudently borrowing money to invest
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The Rewards of Leveraging
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There are de nite potential rewards to leveraging Consider these ve rewards: Reward 1: Leveraging is a forced investment plan The money you borrow is invested up front, and you pay for this investment through required monthly loan payments Reward 2: You can build wealth using another s resources Where you ve got cash ow, but little in the way of investments, you can use someone else s resources to jump-start the wealth accumulation process Reward 3: Leveraging can boost your effective returns While leveraging won t improve your actual returns, it can increase your effective returns (see Jack s story below) Reward 4: You can reach your nancial goals faster Leveraging gets more money working for you sooner than you might otherwise be able to achieve The result You may be able to reach your nancial goals sooner Reward 5: Leveraging can create a tax deduction for interest costs Let s not forget about tax deductions Interest costs are generally deductible for tax purposes when you ve invested the borrowed money I ll talk more about this in Tip 63
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ack borrowed $50,000 to add to his own $50,000 available to invest, for a total portfolio of $100,000 He earned a 10-percent pre-tax return on the
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total portfolio last year, or $10,000 all in capital growth Jack is paying interest of 8 percent on the loan, which cost him $4,000 ($50,000 multiplied by 8 percent) last year After all taxes and interest have been paid, Jack managed to put $5,500 in his pocket last year This represents an 11-percent after-tax rate of return for Jack ($5,500 as a percentage of his own $50,000 is 11 percent) That s right, his portfolio grew by 10 percent before tax (which is 75 percent after tax given our assumptions), but Jack s effective rate of return was 11 percent after tax! That is, if Jack had not borrowed any money, his after-tax
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1 0 1 Ta x S e c r e t s F o r C a n a d i a n s
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return would have been 75 percent His leveraging strategy, however, created an effective return of 11 percent after tax Jack s story is spelled out more clearly in the table below You ll notice from the table that leveraging can magnify your returns so that your effective return is higher than you could achieve without borrowing money In Jack s example, a 75 percent after-tax return was magni ed to 11 percent after taxes
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The Risks of Leveraging
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Now, before you hop on the leveraging bandwagon, you need to understand the downside potential too Check out the table one more time What would have happened if Jack s portfolio had lost 10 percent of its value last year, rather than gaining 10 percent Jack s effective loss from a 10-percent decline in value would have been 19 percent! And this calculation assumes that Jack would be able to use the capital loss to offset capital gains on other investments If he were unable to use the capital losses in this manner, his effective loss would have been 24 percent for the year! Yikes As you can see, leveraging is great when your portfolio is growing in value But when your investments drop in value, the effective loss can sting In fact, the risks of leveraging include the following: Risk 1: Your investments could drop in value We just discussed this one Risk 2: Interest rates could rise As interest rates rise, the break-even rate of return you ll need in order to make leveraging pro table will also rise Risk 3: Your cash ow could suffer Cash ow is critical If you run short on cash, you may be forced to sell investments at a bad time to meet loan payments Risk 4: Margin calls could be made Depending on the type of loan you assume, you may be required to come up with more cash, or liquidate investments, in the case of a margin call A margin call can arise if your investments start dropping in value Risk 5: Tax deductions could be disallowed A deduction for interest costs is generally available when borrowing to invest but it s not guaranteed If interest costs are not deductible, the break-even rate of return in order for leveraging to work will increase I ll talk more about interest deductibility in Tip 63
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