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Jun 1, 2015

Borrowing From Peter To Invest In Paul: Does Borrowing Against Your Home To Invest Make Sense? - Part 1

by Colin Ritchie

Colin RitchieTo quote an oft-repeated line from Hamlet, “Neither a borrower nor a lender be”. To many of us, like my grandfather, these are words to live by (particularly the bit about not borrowing). Traditional wisdom suggested saving until you could pay in cash and, if you had to borrow to buy something like a home, moving heaven and earth until you owned a clear title. As for me, I don’t see things as nearly that clear- cut. While I agree that saving for the future is a wonderful thing and that living beyond your means is the road to ruin, carrying debt isn’t necessarily as evil as some might suggest. I hope to show you at least a couple of exceptions to the general rule, after which I’ll turn the focus to leveraged investing using home equity. Then you can decide if it’s a good thing for you or merely for those receiving commissions. You’ll also see some suggestions that I hope will help tip the odds more firmly in your favour if this path appeals to you. Finally, although I’ll discuss some borrowing options in passing, I will leave a more detailed review of this subject to Russ Morrison, a mortgage-broker friend of mine who excels at this sort of thing.


Is Borrowing Bad?

If you live in Vancouver and have owned your home for a number of years, you are probably proof that leveraged investing can work when fate and fortune align. For most Vancouverites, the growth in home equity has been due mostly to climbing real estate markets rather than shorter amortization periods (or taking advantage of prepayment privileges written into many mortgages that allow you to make extra payments in order to get out of debt sooner). In other words, many homeowners have grown their nest eggs by taking out large mortgages and then watching the asset they purchased with this borrowed money appreciate far more than their interest costs.

Even better, some of them also receive (rather than write) rent cheques each month if they have found someone to live in their basement or coach house; this can mean extra money for mortgage payments, perhaps the ability to finance buying a bigger home in the first place, and also the benefit of writing off some of their interest and expenses related to home ownership.

By the same token, if you borrowed to buy a rental property on the left coast ten years ago, you are also probably feeling pretty good about your retirement
right now (even if you weren’t able to use the “got to live somewhere” or “rent is throwing money away” arguments to justify your decision to buy). In fact, many of my more successful clients, both past and present, have made their money through land ownership. Interestingly enough, this applies to many business owners too: although the business may have paid them a healthy income over the years, the real value, when it was time to close up shop, often lay in the shop itself rather than the other business assets.

Turning away from merely investing in land, borrowing itself is a common business strategy. In fact, some businesses get criticized for not borrowing enough. If they expect to make a 15% profit margin on borrowed loot, then borrowing at 6% to do so can make a big difference to the bottom line, whether it’s by taking out bank loans, writing bonds that are publicly traded, or even
issuing preferred shares that raise money in exchange for paying out dividends (at a stated percentage or according to a set formula).

Even the big banks do this sort of thing, and that seems to have worked out okay for them so far. Anyway, by this stage I hope you get my point: sometimes borrowing to invest can work out very well.

Putting words into numbers, let’s return to the basic homeowner example: if you put $100,000 down for a $500,000 home with a $400,000 mortgage at 3% five
years ago and it’s worth $650,000 now, your return on your investment isn’t merely the 30% increase in value from $500,000 to $650,000 (minus your interest expenses and other costs of ownership). Instead, since you committed only $100,000 of your own cash to buy in, you’ve really made a $150,000 profit (less the expenses just discussed) on an investment of only $100,000, which
equates to a return of 150% before expenses. Thus, by borrowing $400,000 to buy, you have changed your return from 30% over five years to 150% (again, minus five years’ worth of interest). Even if this interest amounts to almost $50,000, you would probably still have about doubled your original investment of $100,000. Even better, if you are renting part of your home or claiming a portion as a home office, the true cost of borrowing can be significantly lower in light of the tax savings.

Is Borrowing Good?

If you’re assuming by this stage that I’m suggesting borrowing to invest is a no-brainer, not so fast. Consider the law of gravity: what goes up pretty often comes down (at least for a while). Even if you believe that certain assetsalways appreciate over the long-term, whether they actually go up during the particular period during which you’re in the market is another question entirely; if you need to sell at a time when the investment gods are otherwise engaged, you probably don’t really care if the stock, home or mutual fund you have to sell now goes through the roof five years from now. Moreover, when talking about businesses and some investments, it’s very possible that some of them never go up in the first place — you might watch as your stock market darling begins
a slow, inexorable slide toward oblivion, until either you jump ship or the company files for bankruptcy.

Even when talking about real estate, it’s also important to remember that there have been some pretty long slumps in the real estate market along the way, despite how much values have grown in places like Vancouver over the last decade or so. Yes, there are pundits who claim that the value of land in places such as Vancouver will never stay down for a prolonged period, for a variety of reasons, and perhaps history will prove them right. On the other hand, it is important to remember there were also a
lot of talking heads who extolled the tech bubble before it burst so spectacularly, as well, few people foresaw the economic meltdown of 2008. Finally, interest rates are at historically low levels, and that won’t always be the case.

Noting these cautionary words, I also suggest that you ask yourself whether you ultimately need to count the risk of losing someone else’s money in addition to your own in order to achieve your financial goals. If you are already on track to retire in style with a few extra dollars to spare, why run the risk of having to forgo your annual trips to the sunbelt during your golden years, just
to earn some extra dollars that won’t really change your lifestyle anyway? Accordingly, I predict that few top-notch financial planners would ever sneer at a couple who were completely debt-free by retirement and with money in the bank to travel the world, even if that meant having to downsize, or unwind any leveraged investing scheme — no matter how lucrative it had been in the past or how much supposed sense it made going forward — to get there. What’s more, perhaps this conservative couple was now able to enjoy their retirement that much more since they didn’t have to sweat every market bounce; how much extra money is that worth?

Again, putting numbers into words, let’s also see some of the potential losses if things go wrong. Assume a client invested $100,000 of this own money, and $400,000 of his brokerage’s, for five years at 4% interest per annum, in an investment that produced exactly enough income to offset the borrowing costs net of taxes. If this total investment of $500,000 was worth $375,000 by the
time he’d had enough, he hadn’t merely lost 25%—which represents where he would have been if he’d invested using entirely his own money—but, since he’d originally invested $100,000 of his personal wealth, he would have lost 100% of his original investment plus the 25% on top of that. He would have had to come up with a further $25,000 from other sources after learning his original
$100,000 stake was in the wind.

Strategies For Borrowing Against Your Home

For the rest of this article, I’m going to narrow my focus from leveraged investing in general to leveraging the equity in your home in particular. I will talk very briefly (for me) about some of the ways to borrow if you want to use your home as collateral. As mentioned, I will leave it to my friend, mortgage broker Russ Morrison, to expand and expound upon some of these options (and perhaps add a few of his own). Cutting to the chase:

Property Tax Deferral Programs (PTDP): What’s this, you say? If you are in a province like B.C., there is a deal available to seniors (55+ in B.C. with 25% equity in their home) whereby the province will pay property tax to your municipality for you if you apply, get approved and pay the registration fee. You don’t have to repay this debt until you move or die. Until then, the province of B.C. charges simple interest at 2% less than their own borrowing costs. Right now, this means borrowing at 1% (the rate is adjusted to current conditions every six months) and knowing you aren’t paying interest on the interest. If this money is invested instead of put toward more expensive debt (e.g., credit card debt, car payments or even mortgage top-ups), your investment doesn’t have to work very hard to break even. If you are going to invest, consider using this money to fund a TFSA contribution for the tax savings, particularly since you probably can’t deduct the interest on the deferred tax anyway. Alternatively, using it to make RRSP contributions may also make sense, such as if you’re still working but expect to be in a lower tax bracket shortly.

Reverse Mortgages: The biggest player in this game in Canada is CHIP. The basic premise is that they will lend you up to 40% of the equity in your home and not ask for their money back until you move or die. This allows you to access a lot more cash right away than the PTDP. If you do borrow to invest, the interest is tax-deductible if you pay it back each year rather than allowing it to compound with your outstanding debt. Speaking of interest, the charges are generally higher than a mortgage or secured line, but, from a cash flow perspective, you don’t have to worry about paying the interest costs as you go (if you can’t afford to do so), repaying principal prior to moving, or requalifying for the loan every few years. In the past, reverse mortgages were generally variable-rate only; however, some fixed-rate options, similar to traditional mortgages, are now available if you want to protect against rising interest costs eating into your equity more quickly than expected.

Secured Lines of Credit (otherwise known as a “HLOC”): By using your home as collateral, you should be able to borrow money significantly less expensively than if you merely apply for a general line of credit that doesn’t give the bank priority over specified assets — a bonus to them when multiple creditors come calling. However, the bank may want both spouses to guarantee the loan, which could now mean exposing your partner’s assets to the bank — including a share of the house — whereas previously it was protected from their clutches. HLOCs are generally at a variable rate, and that can mean lower borrowing costs today but higher tomorrow if/when rates do eventually spike. If doing leveraged investing, you should also determine whether payments stretch some budgets and ultimately affect how much you decide to borrow. I also suggest learning about the circumstances under which the bank can call in the loan.

Remortgaging or Taking Out a Second Mortgage: This is something that is used far more for investing in the borrower’s own business than in the stock market or other investment opportunities. A second mortgage will probably be at a higher rate than the first mortgage, which begs the question of whether there are other options that might work better. Likewise, remortgaging and blending deductible investment debt with non-deductible personal debt doesn’t always make the most tax sense. This is because you are able to deduct only a fixed portion of the interest payments related to the invested cash, and it doesn’t allow you to earmark how your payments are allocated between your deductible and non-deductible debt. For example, if only 15% of the debt is allocated toward investing, then you will always be able to deduct only 15% of the interest paid each year. Conversely, if you separate the personal and investment/business debt, you can earmark which repayment dollars get applied to each obligation. As a result, it usually makes sense to pay down the non-deductible debt first if it is at about the same interest rate, as the true cost of borrowing to invest is calculated after taking into account the tax deduction you’ll receive from doing so. For example, if borrowing at 4% in B.C. while in the highest tax bracket, your true cost of borrowing if the loan is 100% deductible takes into account that you’ll get 45.8% of this back at tax-time; that means you’re really only paying 2.17%. Finally, both of these options will probably require you to be paying back some of the principal as you go, which needs to be addressed when calculating your cash flow impact.

All-in-One and Readvanceable Mortgages: While popular down under, this option is still relatively unexplored in the Great White North, although there are several providers at this point. The basic premise is that all of your debt is consolidated into a single uber-mortgage, resulting in a lower rate than what you’d pay if you’d kept all the loans separate. As well, the interest is simple rather than compound (i.e., you don’t pay interest on the interest), although, whether this saves you money compared to a traditional mortgage (assuming all else is equal, such as that you’re paying down the same amount each month) depends on the difference in rates. On the other hand, the all-in-one and readvanceable mortgages offer some extra features that are ideal for people using their home equity as collateral. First, you aren’t saddled with principal payments: you can go interest-only. Second, for some products, down the road you can reborrow any amounts you do pay toward principal, which gives you a lot more flexibility. Third, many products allow you to establish subaccounts so you can track different debts separately. In other words, you can have a separate subaccount that is dedicated entirely to a 100% deductible investment loan.

Finally, when making payments on your debt, you can allocate where it gets applied. Since everything inside the account is charged interest at the same rate, there are some huge tax savings over the years if you apply all principal payments toward the non-deductible subaccounts first, and then pay interest-only on your investment loans (at least until all your non-deductible debt has been retired).When considering this option and investigating alternatives, I suggest looking at things other than merely interest rates, such as whether you can lock in rates for some or all of the debt (as with traditional fixed mortgages), whether you need to pay monthly fees, and whether you can reborrow any money you’ve repaid on your non-deductible debt to finance future deductible loans. Since this last feature is one of the key tenets of the “Smith Manoeuvre,” which I will discuss in Part 2 of this article, you need to know if your bank or credit union’s proposed product will provide this feature.

Part 2 will be published in the July/August issue.

Colin S. Ritchie, LL.B., CFP, CLU and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at