* This is the first post in the “Leveraged Investments” series. *

There has been a lot of discussion lately in blog world about leveraged investing so I thought I would add my take on the situation.I decided at the beginning of this year to look into the feasibility of using some leverage to buy dividend stocks.I figured with my long time line for this project, the favourable dividend taxation rates, and the tax deduction on the interest, that there was a reasonable chance to implement an investment plan which would eventually pay for itself from a cash flow point of view and provide an eventual net profit from the dividend flows and capital gains at the conclusion.

I have three posts prepared on this topic, today’s post outlines “the plan”, next post will cover all the risks (and there’s a lot of them) and some steps I’m taking to manage the risks, and the last post will look in depth at my analysis of my personal interest rate risk which includes my mortgage as well the investment loan.

The basic plan is to use my home equity line of credit to buy dividend stocks in a taxable account. Stocks would be Canadian dividend stocks, strong record of dividend increases, great companies.Safety of the companies is of utmost concern.

The main reason I was inspired to think of this plan is because of the incredible record of dividend increases that a lot of these companies have had (10% to 20% over the last 10 years).I’m well aware that this is an aberration however that’s what got me interested in this type of investment in the first place.

The other reasons I’m keen on the plan are because of the tax deductibility of the interest on the investment loan and the light tax on dividends. Another attraction is that if the plan is at least moderately successful, it won’t cost me anything to implement.

Here is a model of a scenario that I’ve analyzed.In actual practice I wouldn’t buy $100k all at once, accumulation will be much more gradual and I don’t have a specific upper limit.

Some numbers – my marginal tax rate is 43%, tax rate on dividends is 21%. I set up a model where I buy $100k of stock yielding 3.1% and the dividends increase 5% per year. Interest rate is 6% and never changes.All figures have been discounted to 2007 dollars using a 3% discount rate.

$6000 is paid in interest each year, $2603 tax rebate received each year.

In the first year the dividend income is $3100, after tax dividend income is $2449 so the profit for me is the interest – tax rebate – net dividend income = -$948 for the first year.

In the second year, the dividends have increased by 5% so the annual profit = -$826.

In year eight the annual profit is now positive at $49 and it continues to grow after that.

At the end of year 14 – the total of all the cash flows in today’s dollars add up to $436 which means that at that point in time, my overall cost at that point is zero and I have $436 in profit from the dividends.

By the end of the plan (25 years), the total of all the annual net profits/losses from dividends is $17,866 in 2007 dollars.To calculate the potential capital gain I took the gross dividend income in year 25 ($9,998), divide by 0.05 (I’m assuming a 5% yield) which gives me a $200k valuation of the equities.I calculate that if I were to sell all the stocks at that time and pay off the loan I would have a 2007 present value of $38,500.Adding the net dividend income + net gains gives me $56,374 in 2007 dollars.

Bottom line is that in this model I’m paying only $3620in today’s dollars over the first seven years to get things started. Even in year one, 84% of the interest cost is covered by the tax rebate and net dividend. By the end of year 8 my cash flow is now positive and by year 14 I’ve broken even in that the annual profits I’ve received from the dividends have paid for my initial costs.If the plan works exactly as the model does then I would make a profit equivalent to $56,374 in 2007 dollars.

You might have noticed that like most leveraged plans this one didn’t mention any of the risks involved….that will change tomorrow when I will go through every risk I could think of and how I’m planning to mitigate those risks.

Here is my spreadsheet for this model: Div Sheet

* See the next post in this series “The Risks”.*

## 24 replies on “Leveraged Investments – My Grand Plan”

Interesting…but you lost me with the math.

How much of your house do you need to have paid off before you can obtain a significant HELOC?

How does the interest rate work? I assume it is variable and linked to prime?

Thanks for the comment MG.

I believe banks will lend up to about 75% of a house value which would include the mortgage amount and HELOC. So if you have a $400k house and a $250k mortgage then you should be able to get a $50k HELOC. In this case the mortgage owing + HELOC would always equal $300k so as you paid the mortgage, the HELOC would increase.

Secured line of credits are usually at prime which is currently 6%. I’m not sure exactly how this is set but I believe it’s related to the Bank of Canada rate which of course floats.

Mike

Great post Mike!

Just one thing, the banks will now lend up to 80% LTV. Also, you assume that prime will stay @ 6% forever, you may want to revise that estimate upwards a little.

FT

Thanks for the comment MDJ. I have looked at different interest rate scenarios to see what impact they have on the plan and it’s quite significant.

I thought 6% was reasonable, it may end up not being that accurate but between the interest rate estimate, the dividend increase estimate, the capital gains – there are a lot of assumptions made so this really is just a rough model.

Mike: Couple of comments. The lending limit is now 80% of the value of a house. The prime rate is BoC rate + 1.75%.

If anything, I think your numbers are a bit conservative because once you are cash flow positive, you should assume that the excess cash is reinvested.

How do you limit your leverage? I have a strict limit of 10% of portfolio.

In response to MDJ comment about interest rates, when I rerun the numbers for different interest rates, I get the following net present values:

6% $56,374

7% $46,023

8% $35,672

9% $25,320

10% $14,969

CC – you’re right about not reinvesting the divs impacting the performance of the plan. I’ve sort of decided that’s how I want to do it because I’d rather use those dividends to pay off mortgage or contribute to rrsp. If those options are not available then reinvestment of dividends could occur.

Mike

Mike: Even if you’re going to use the dividends for something else, you should leave them in the model so you can accurately calculate the return (if you just remove the dividends, you’re underestimating your return).

You *COULD* get a set interest rate if you got a second mortgage (or paid off your first mortgage and then re-borrowed against your property for investment purposes).

I’m not saying this would necessarily be the best approach, but if you wanted to be more certain about some of your numbers, that’d be a way to lock down the interest rate (it *MIGHT* be possible to get a fixed rate loan for equity purchases, not sure how you’d do this, but someone else might know if this is or isn’t possible).

Great post BTW!

Thanks Mr. C.

The problem with leaving the dividends reinvested is that I would have to pay more money out of pocket to do the plan. If I reinvest the dividends then I’ll always have to pay for the portion of interest not covered by the tax rebate as well as the tax on the dividend. One of my biggest goals for this plan is to only pay minimal amounts into the plan in the beginning and eventually break even in terms of cash flow. If an investor had lots of cash flow available it might make more sense for them to reinvest the dividends.

I’m not an expert on calculating return but I would have to account for the money I put into the plan as well which would at least partially offset the increase in value with reinvested dividends. I’m not suggesting that reinvesting the divs is a bad idea but I would have to invest more of my own money into the plan in order to make it happen which I don’t want to do.

Another reason is that even if I did keep the dividends in the plan I would want to invest them outside the leveraged portfolio so that if I wanted to cash them in, it wouldn’t affect the interest rate deductibility of the loan. Dividends also make the ACB harder to calculate.

Mike

I think the valuation calculation is also quite conservative, as it would give a value of $62k ($3,100/0.05) in the first year (instead of the $100k we know it to be worth)

You’re right, it doesn’t work too well for the first year!

I think this one is impossible to estimate with any accuracy. From what I understand if interest rates go up and investors can get higher guaranteed rates of return, they tend to sell their equities and buy GICs or bonds. To try to account for that, I estimated a more conservative yield of 5%. Right now you can buy BMO @ $70 with a 4% yield which is comparable to a GIC. But what if GICs could be gotten for 6% next year? In order for the BMO to yield 6% the price would have to be $45 which is quite a drop. I’m sure the connection is not that solid in real life, but my point is that if interest rates are higher at the time of dissolving the plan, that will have a negative effect on the capital gains. Since it is a long term plan, the valuation for the near future isn’t that important.

Mike

I forgot to answer CC

“How do you limit your leverage? I have a strict limit of 10% of portfolio.”

I’ll be covering this with Friday’s post. My limit is determined by looking at cash flow in terms of how much interest costs I can handle.

Question Mike, are you using a re-advancable mortgage? Or just a plain HELOC?

MDJ – It’s just a plain old HELOC.

I think the re-advancable mortgage is a more appropriate tool if you want to invest regularly in mutual funds and/or keep your total debt constant. Neither of which I’m doing.

Mike

I played around with your spreadsheet, and how I compensated for interest payments in the beginning (and dividends later on) was just to add interest to the principle (borrow more in the early years) and deduct the dividends from the principle. This lets you see its performance “in isolation” (whereas, obviously in reality you’d do what made the most sense with the money when you received it)

That makes sense Mr. C.

For any kind of future planning it’s good to play with the numbers in order to get a better handle on what could happen.

Mike

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