If you had a chance to watch the film starring Danny DeVito called Other People's Money (OPM), you will only have a disdain for the title and the the ugly, mean character he plays. Except, when it comes to increasing your own personal wealth.

There is a complelling argument that suggests borrowing money for the purpose of investing can significantly improve your wealth over the long term This article will discuss and summarize the merits of using leveraging (borrowing) or using Other People's Money (OPM) to realize your financial goals earlier.

So, what is leveraged investing? Accordingly, leveraged investing is simply the strategy of prudently borrowing money to invest. This strategy can allow investors to achieve higher effective rates of return and accelerate the wealth building process when utilized over the long term. For leveraged investing to work best , you need to maximize long-term investment returns. Putting money in low yielding interest bearing deposits won't accomplish this goal.

So, borrowing money with interest charges makes me rich? Yah, right!! I already borrow money on my credit cards and the only people getting rich are the AMEX and VISA organizations of the world!! Just what the heck are you talking about?

OK – that's a good question – so let's try and answer it. To do so, let's address the idea that debt is BAD! Well, is it?

If you look at personal consumption credit cards, there is a strong argument for saying that Debt is bad. You purchase say, a new coat, on your credit card with interest rates that are looming at 17 percent, and purchase an asset that immediately begins to depreciate. While the coat looks great on you, it will fetch only a fraction of its value at the annual neighborhood garage sale. And the interest charges – well you've just got to pay those and suffer the ruthless interest charges.

What about using OPM to purchase an Appreciating Asset? Even where interest costs are high, the debt may still be good debt provided the assets acquired grow at a high enough rate. Where your interest costs are low, the debt is almost good debt since growth of the assets is likely to be high enough to make the debt worthwhile. Your home mortgage, for example, likely falls into the category of debt used for an appreciating asset, at a low interest rage. This generally classifies the debt as good debt, despite the fact that the interest charges are no deductible.

And, what if the interest charges are deductible on an appreciating asset? When leveraging for investments, your debt generally falls into this category. In this case, you are borrowing to purchase investment assets that are expected to appreciate in value at a rate above the after tax interest paid. The investments secure the debt so that the interest costs are lower and interest is generally deductible. This type of program makes sense!

So, your probably saying to yourself, “Yeah, that sounds great! Deducting interest costs on an appreciating asset. But, it's probably just great for rich people!” Well, nothing could be further from the truth. Provided you have sufficient cash flow to make the required payment on the debt, you can benefit from this program and its rewards.

That being said, just what are the rewards of leveraged investing? For starters, you are building wealth using other people's money. You see, there are really two ways to build wealth: Through properly utilizing 1) your time and energy (in employment, for example) and 2) your assets (money, home equity, and other r assets). For many Canadian s, their time and energy represents their greatest opportunity for building wealth. The problem is, that while they have cash flow from their work, they don't have enough in assets to create a sufficient nest egg as soon as they would like. Borrowing to invest allows you the opportunity to make use of someone else's money to build your own retirement portfolio.

In the following example, management consultant Jake Kingfield is wondering whether he should consider leveraging to accelerate his retirement program. He has $6000 of cash available after taxes to invest each year and he has a 20-year time horizon. The two options he is considering are 1) simply invest $6000 annually and grow that money for 20 years or (2) use the $6000 annually to pay the interest costs on an interest only loan for 20 years. Let's see:

Pre-Tax Return	Account Value No Leveraging	Account Value Leveraging	Increase ($)	Increase %
0%	$120,000	-	($120,000)	-100%
3%	$161,222	$90735	($70,487)	-44%
5.10 %	$199,531	$199,531	- 0 -	0%
7 %	$245,972	$352278	$106,306	$43%
9%	$305,960	$579,456	$272,496	89%
12%	$432,314	$1,114,330	$682,016	158%

Assumptions:

· 20 Year Investment horizons

· Invest $6000 in the no leveraging scenario

· Use same $6000 cash flow to borrow $133,333 at 9 % in leveraging scenario

· Sufficient investments are liquidated to pay off the loan and resulting capital gains taxes at end of 20 years

· 50 %marginal tax rate

· Annual returns consist of 100 % deferred capital gains.

You can see from the graph that if the returns are below 5.1% annually, that there will be a loss through leveraging the investment. That's a risk. However, if your returns exceed that figure, you are in a positive situation. If you look at historical returns of major indices such as the TSE 35 (12.4 %) and the S&P 500 (14.8%), it is easily conceivable that you could be in the more positive returns if your investment goals are long term. Using the 12 % annual pre-tax rate of return (similar to how the TSE 300 performed before this messy bear market) Jake is worth over $1 million and is $682,015 ahead even after paying off all the debts of the loan. That's a significant difference.

Another reward of leveraging is the ability to deduct the interest costs on the borrowed money. For every dollar of interest you pay, you can expect to save an amount equal to those interest costs multiplied by your marginal t ax rate. For example, if you were to pay $5000 in interest costs this year and your marginal tax rate were say, 46 %, you would save $2300 in taxes as a result of the deduction. This tax deduction is claimed on your tax return as a “carrying charge” and is deducted against all other types of income reported on your tax return. This can be quite useful as it reduces your income just like an RRSP!!!

And that brings us to the other main attraction of leveraged money – mainly that it's non-registered monies. Don't get me wrong, RRSP's are great – they accumulate tax deferred and they reduce your income. But come age 69, you've got to start taking the monies out and every dollar that goes into your pocket is considered income! If you speak with well-healed seniors who have had good careers, you will find that with their forced withdrawals from RRSP's, that they are paying more tax than ever before. And if they are still working after age 69 because of sheer love for their jobs, the tax implications are crazy! Tax, Tax, and more tax to pay.

The idea of having non-registered monies that you control, not the government, creates a strong incentive to pursue a leveraged strategy in that they are not taxed upon usage or withdrawal. And the fact that you can deduct interest charges from the investments means you can have the deduction similar to an RRSP with the freedom of non-registered investments.

So, this sounds great, but what about the risks of leveraging? There are some:

Firstly, your investment could increase in value. If you refer to the chart, if your annual returns are under 5.1%, you are in a cost situation. That's why it's important to be very selective about your investment strategy and develop a properly diversified portfolio with conservative expectations. It's also important to work with a trusted advisor who can guide you through the pitfalls of this program.

Secondly, interest charges could increase and this could impact your personal cash flow. That's why it's important to leverage to an amount that does not exceed your tolerance level (we call it your sleep disturbance level). Establishing an emergency fund to cover payments for the debt for 1 year is a prudent step to take before embarking on such a program.

Thirdly, you could get a margin call. That is where the value of the investments and the loan value become significant and the lending institution calls the loan. An excellent way to not face the scrutiny of this call is again to leverage intelligently and not borrow the maximum allowable amount. If for example, the lending institution is willing to lend you up to 50 percent of the value of the investments in your account, borrow 30 percent instead. This will give you some breathing room.

And there's always the threat that Revenue Canada might change the rules and disallow tax deductions for interest charges on investments. Then again, those guys could go after your tax efficient RRSP and other tax preferred vehicles like your principal residence.

Finally, you just might get greedy and over leverage. That's why it's important to work with a trusted advisor who can keep you on track and remind you of your goals.

All right folks, so we've beaten this topic to death. Let's take a break and allow for a digestion process to occur. If you have any questions regarding leveraging or investing in general, please feel free to drop me a line.

This article was written by John Klotz., B.A., CFP., CLU., CH.F.C., RHU., You can reach John at (416)-595-7484 ext. 305 or email at johnk@lms.ca