There’s been a lot of posts on leverage lately in the blogworld so I didn’t think it would hurt to have one more…
Also – I’m in no way advocating anyone use leverage for investments unless they are comfortable with the extra risks.
As Financial Blogger and Tom Bradley pointed out, leverage is an instrument that almost everyone uses when they buy their house. Although most people buy a house to live in, not as an investment, it’s an example of where people are using leverage and they might not even realize it.
If you ask people on the street about how they feel about borrowing to invest they might give you a lot of negative feedback. I suspect this is a holdover from times when margin accounts were the only way to borrow for investing. The problem with margin accounts is that if your investments drop in value enough then you have to come up with cash to pay the difference which is why certain investors were running out of windows in 1929.
My opinion is that leveraged investing can be a useful tool but definitely entails extra risk. However it occurs to me that sometimes the idea of leveraged investments can be a question of semantics.
Consider the following:
Person A gets a $200k mortgage on his house with a 25 year amortization. After five years, his mortgage is $185k and he also has $10k in cash that he has saved. This person decides to invest the $10k into a dividend stock, let’s say…BMO. So now he has a $185k in mortgage and $10k of stock.
Person B also gets a $200k mortgage on his house with a 25 year amortization. After five years, his mortgage is $175k but he has no extra cash to invest because he has been making extra mortgage payments. This person decides to borrow $10k from his secured line of credit and buys $10k of BMO as well and gets the tax rebate on the interest paid.
According to popular wisdom, person A is the epitomy of responsible investing using good old cash to buy his stock. Person B on the other hand has made a deal with the devil and plunged into leveraged investing.
So what’s the difference between the two? The only difference I can see is that Person B can write off his interest on his investments and Person A can’t. Obviously there are interest rate differences but I’m ignoring those since they shouldn’t be too significant.
Moral is – if you don’t make extra payments on debt and use cash to do investments then you would be better off to put that cash into the mortgage and then borrow it out again for those investments and get the tax rebate.
And yes, I realize that this logic was the genesis of the Smith Maneuvre but rest assured that I don’t recommend that particular strategy.