Using a HELOC as an investment strategy: not as taboo as you might think

Q. I wish to leverage my home equity line of credit (HELOC) to invest in dividend-paying investments. How would you advise I approach this? Is this an effective tax savings tool? Is there any financial institution or products you would advise?
– Martha

A. You know, Martha, in some circles leveraging—or borrowing to invest—is a taboo subject. I find that funny, because there is much less controversy when people borrow to:

• Buy a car, which depreciates in value;
• Buy a house, which normally appreciates, but can decline;
• Take a vacation as a lifestyle investment.

So why is there controversy around borrowing to invest? Probably a lack of understanding, coupled with the fact that when leveraging goes bad, it’s not good.

Let’s talk about leverage. If you borrow $100,000 at 5%, what rate of return would you have to earn on your investments to break even?  Would you guess 5%?

Most people would agree with that answer; it sounds logical, right? I mean, if you borrow $100,000 at 5% and paid $5,000 in interest costs then that would mean you would have to make $5,000 on your $100,000 investment to break even, which is 5%. Got it? Good.

But that answer is wrong!

The break-even return on investments is lower than the borrowing cost when you take into account:

1. Simple vs. compound interest over time;
2. The interest tax deduction and;
3. The tax deferral on the investments.

Still skeptical? Consider a free trial of Talbot Stevens’ leverage software to see for yourself. (Here is a demonstration of the software.)

When you make annual interest payments on a loan, this is considered simple interest. For example, in the first year, you would pay $5,000 in interest charges on a $100,000 loan at 5%. In the second year, you’d have the same interest charge because the loan is still $100,000. If you plotted your total interest payments over time on a graph you would see a straight line sloping up toward the right.

Contrast that with a $100,000 investment earning 5%. After the first year, you’ll have $105,000. In the second year you’ll have $105,000 plus 5%, which brings the running total to $110,250—and up it goes each year. This is compound interest, which would produce a graph that curves upward toward the right.

To summarize that point: when you make annual interest payments on a loan, simple interest applies, whereas investments compound. The longer you hold the investments, the greater the compound effect and the lower the return needs to be on the investments to break even.

Now, let’s consider the tax deduction. When you borrow money to invest, the interest cost is considered a carrying charge on your tax return, which creates a tax deduction no different than an RRSP contribution. Looking at this in concrete terms, if your marginal tax rate is 30%, your after-tax cost of borrowing is 3.5%. Now, as with any strategy, I’d recommend you take the tax savings and invest it or pay down non-tax deductible debt.  The benefit of investing the savings earned through your tax deduction is not just that you potentially build more wealth, but that it becomes easier to measure the success or failure of the leveraging strategy. Many people look only at the value of the leveraged investments and forget about, or discount, the value of the tax deduction. You need to account for the value of the tax deduction to get a full picture, and reinvesting it is a simple way to do that.

The final point is the tax efficiency of your investments. The less tax you pay on your investments as they grow, the more money you have invested, and the more the return compounds over time. With that in mind, do dividend-paying investments make sense? What’s your reason for selecting dividend-paying investments? Is it because you feel those investments are safe and provide good returns? That’s an OK reason, but if you could find investments with a similar level of risk and rate of return which paid less in distributions/income, then you may be better off from a tax perspective.

Were you thinking of using the dividends to pay some of the interest charges? You can do that but I wouldn’t advise it. Don’t do leverage unless you can easily make the interest payments out of your regular cash flow.

Here are a few things to consider:

1. Use a separate HELOC for your source of investing funds. This will make your taxes easier.
2. Hold a separate account just for the leveraged investments; again, this will help with tax accounting.
3. While you’ll want to invest according to your specific profile, one possible strategy is to buy broad market index investments.
4. Don’t use systematic withdrawals from the investment to make interest payments.
5. Plan to invest for 10 years or more.
6. Remember, leveraging magnifies returns up and down. If your $100,000 goes to $80,000 and you have to sell, you will still owe the bank  that “lost” $20,000 (the difference between the $100,000 you borrowed to invest, and the $80,000 value of your investment when you sold).

Finally, when it comes to leverage don’t think just about investment accumulation but also think about how you can use the interest tax deduction. Here are a few quick thoughts:

1. Will it reduce your income so you can get more of the Canada Child Tax Benefit, GIS, OAS, and the Age Credit?
2. Will the tax deduction offset the tax owed on RRIF or INVESTCO withdrawals?
3. Can you use the tax deductions to pay off your mortgage faster and accumulate investments i.e. the Smith Manoeuvre.
4. Interest on the interest that is tax deductible is also tax deductible so consider paying off non-tax-deductible debt before making interest payments on your leveraged loan.

I hope I’ve given you some things to think about Martha and I haven’t made it look like everyone should run out and start leveraging. If you have the cash flow, borrow within your means, stick to a broad market investment, and have a long time horizon, you’ll greatly improve your odds for success.

Allan Norman is a certified financial planner and Chartered Investment Manager with Atlantis Financial Inc. in Barrie, Ont. He can be reached at [email protected]

This commentary is provided as a general source of information and is intended for Canadian residents only. Allan offers financial planning services through Atlantis Financial Inc.

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