Saving within your means
You’re starting your practice and you want to start building your savings quickly because you have plans! And to achieve them, you want to rely on your professional income, but also on the income you can earn from sound investments.
The catch is that early in your career, cash is usually more limited. So how do you go about building an investment portfolio whose income will quickly put you on the right track?
Leverage loan or not?
There is a strategy that involves borrowing money to invest, usually in non-registered investments. The principle is that the return generated by the investment will be greater than the interest costs of the loan.
So far so good. But beware of the transition from principle to reality!
So far so good. But beware of the transition from principle to reality!
- If an advisor suggests a leverage loan, first consider your risk tolerance. The leverage loan strategy amplifies the results obtained: when the markets are up, your gains are bigger, but if they’re down, your loss is bigger too.
- Also consider your borrowing capacity and your current savings. Early in your career, sudden setbacks are more difficult to take. You can undoubtedly borrow and pay the interest on a loan. But what will happen if the markets suddenly fall: will you be able to absorb the loss without compromising your financial future?
An example
You borrow $50,000 at an annual interest rate of 2.5%, which means you will have to pay $1,250 in interest charges each year.
- If the markets are up, all is well.
- If they’re down, you have to be able to absorb a capital loss that could be as much as the full amount borrowed, i.e. $50,000. Think about it!
| Gain scenario | Without leverage loan | With leverage loan of $50,000 |
| Capital invested | $50,000 | $100,000 |
| Capital from the loan | N/A | $50,000 |
| Return (6.0%) | $3,000 | $6,000 |
| Interest (2.5%) | N/A | ($1,250) |
| Net return | $3,000 | $4,750 |
| Initial loan repayment | N/A | $50,000 |
| Final annual result (based on the original amount minus the loan) |
$53,000 | $54,750 |
| % return on initial capital | 6.00% | 9.50% |
| Loss scenario | Without leverage loan | With leverage loan of $50,000 |
| Capital invested | $50,000 | $100,000 |
| Capital from the loan | N/A | $50,000 |
| Return (-10.0%) | ($5,000) | ($10,000) |
| Interest (2.5%) | N/A | ($1,250) |
| Net return | ($5,000) | ($11,250) |
| Initial loan repayment | N/A | $50,000 |
| Final annual result (based on the original amount minus the loan) |
$45,000 | $38,750 |
| % return on initial capital | (10.0%) | (22.50%) |
Are the loan interest costs deductible?
The interest on your loan may be deductible, but for it to be so, the borrowed money must be invested in investments that pay interest or dividend income.
- If you buy shares of a company that does not expect to pay a dividend,
or
- if you invest in registered accounts (RRSP, TFSA, RESP),
the interest on your loan will not be deductible. You must invest in a non-registered account to be able to deduct the interest.
However, there may still be some benefit to investing in a registered plan:
| Account | TFSA | NON-REGISTERED |
| Return | 6.00% | 6.00% |
| Interest | (2.50%) | (2.50%) |
| Net return | 3.50% | 3.50% |
| Tax | 0% | (2.67%)* |
| Rendement net d’impôt | 3.50% | 0.83% |
*At the maximum tax rate of 53.31%%
Final word
Early in your career, the leverage loan strategy is riskier: your risk tolerance and your borrowing capacity are still low. In addition, finding yourself with a large debt when you are still building your savings could become very uncomfortable and compromise your future possibilities.
Be cautious and talk to your advisor. Ask him all your questions and take advantage of his financial intelligence. It can help you avoid many pitfalls and point you in the right direction!
Anik Bougie, LL.M. Fisc., F. Pl., TEP
Practice Leader, Financial Planning and Taxation
The information contained herein has been obtained from sources deemed reliable, but we do not guarantee the accuracy of this information, and it may be incomplete. The opinions expressed are based upon our analysis and interpretation of this information and are not to be construed as a recommendation. For any questions, don’t hesitate to contact your wealth management advisor or your tax specialist, accountant or legal advisor.
