The Pros and Cons of Leveraging

The word "leveraging" frequently raises red flags. Often, the only time the public hears of leveraging strategies, is when a strategy has failed... at times spectacularly. Because of the largely negative press, it is often forgotten that if used properly leverage can be quite advantageous.

What is leveraging?
Simply put, leveraging is borrowing to invest. The most familiar use of leverage is using a mortgage to buy a home. In return for a down payment you receive funds to purchase an asset that would otherwise be too expensive. The hope is that the home will appreciate in value, and when you sell you will be able to realize a profit over what you bought it for (including interest payments).

This is the principle behind leveraging. You gain access to a larger amount of capital and hopefully earn a return high enough to make a profit. If your investments perform well, the use of leverage can greatly magnify those returns. This of course is the appeal.

The downside...
Of course, there is some risk. Just as gains are magnified, so are losses. As well, increases in interest rates may also cut into your profits or add to your losses. It is important to enter into any leveraging strategy with these risks in mind, and take steps where possible to lower the risk level. For example, investing in a well diversified portfolio will help guard against losses and enhance returns. Choosing a fixed-rate loan over a variable rate will also protect you against rising rates.

There are a number of ways that average investor can benefit from leveraging:

Investment loans: This is leveraging at it’s most basic. You use borrowed funds to invest with the hope that returns outpace the interest on the loan. In Canada, you can deduct the interest paid on loans for certain investments, which make this strategy much more appealing, and reduce the effect of interest rates eating into your returns.

RRSP loans: When you borrow to invest in your RRSP, you get two advantages. First, you get the tax deduction for the larger RRSP contribution. Secondly, the growth of your investment is tax-sheltered within the RRSP which will enhance your returns.

Universal Life Insurance: The tax-advantaged status of Universal Life makes it an excellent vehicle for a number of leveraging strategies. Check out the Retirement Income Maximizer and Investor Plus strategies on my website for examples of how you can benefit.

Is Leveraging for You?
Leveraging strategies range from the basic to the very sophisticated and involve varying degrees of risk. Whether or not you could benefit depends on your financial situation, goals and comfort level with taking on risk. It’s definitely not for everybody.