Welcome to May everyone! I hope you’re doing well and getting ready to enjoy the spring and summer weather, I know I am!
Today’s article comes from a reader question in regards to my strategy of using leverage (loans) to invest. Before proceeding further, I will emphasize some key points:
- This article is about using leverage (loans)
- This article is not about using margin loans (I personally do not utilize margin loans at this point in time)
- I am not a financial advisor, if you seek to pursue using leverage, please educate yourself as much as possible beforehand and seek financial advice from a professional on how to effectively pull this off
The thought of using loans to invest is interesting and can offer a wealth of opportunity. To understand why someone would want to use leveraged investing, you should consider the different types of interest; simple interest and compounding interest.
Simple interest is what you’ll typically find in a loan. This means that the interest does not compound on the principal amount. As you pay down the principal, the interest also decreases.
Compounding interest is what you’ll typically find in investments. This means that the interest (or in this case, the dividends) compounds overtime. Example: You invest $100 at a 10% yield. Over the course of a year, you will generate $10 in dividends. If this $10 is reinvested and the yield remains the same, you will generate $11 in dividends.
The above graphic demonstrates compounding versus simple interest. Now we know that loans are typically simple interest, and that investments (especially if they’re on DRIP) are compounding interest. This starts to create a very interesting scenario: over time, loan payments will eventually shrink and our investment will compound.
In this scenario, you could theoretically carry the debt forever; but not everyone is comfortable doing so. Instead, the majority of people (myself included) will be more inclined to pay down debt over time. This affects the Simple Interest portion of the graph above. Rather than being a straight line gently rising, it begins to look more like this:
Now we have an interesting inverse relationship where over time, our investments compound interest, while our loans simple interest payments decrease.
To maximize the effectiveness of this; we ideally want to let our investments compound as much as possible while carrying the debt through our own cashflow. There is a tipping point however, once your portfolio is wide enough horizontally (you hold many stocks) or once your portfolio is tall enough vertically (you hold a substantial amount of a few stocks) where retained dividends may be used to cover the loan payments.
It gets better though. Let’s talk taxes.
In Canada, there are 3 primary accounts most people will use to make their investments in:
- TFSA
- RRSP
- Non-registered (taxable)
For the purposes of this article, we will focus on the non-registered (taxable) account.
Holding Canadian companies that pay an eligible dividend in your non-registered (taxable) account produces a dividend tax credit. This tax credit is roughly 15% of your eligible dividends in a taxable account. This is the basis of the: “dividends are taxed favourably in Canada” idea, where your eligible dividends receive a credit to avoid double taxation. This is done because technically the corporation you’re receiving dividends from has already paid taxes – the purpose is to avoid double taxation.
So your dividends are taxed less! Great!
In Canada specifically, the interest on borrowed money (loans) may be tax deductible if the loan was used to purchase income generating assets, such as dividend stocks. This only applies within taxable accounts, such as the non-registered account. The interest from our loan can become tax deduction from our total income. If this interests you, I recommend further research and consulting your financial advisor. I may also write further articles on this topic in the future 🙂
Hope this helps!
