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September 10, 2019 | Losing it

A best-selling Canadian author of 14 books on economic trends, real estate, the financial crisis, personal finance strategies, taxation and politics. Nationally-known speaker and lecturer on macroeconomics, the housing market and investment techniques. He is a licensed Investment Advisor with a fee-based, no-commission Toronto-based practice serving clients across Canada.

Trust. What’s bigger than that?

Do you trust your bank? Your employer? Your spouse? Mortgage broker? Insurance dude?  Financial advisor? How about your accountant? Or some pathetic blog?

It’s at the heart of the following note I’ve just received from Angie. But first, an epic MSU.

“You are the guru of financial literacy, net worth messiah and Darth Vader of ignorance,” she writes. “Thank you for keeping us, humble disciples of your daily financial mana, informed and entertained. Me and my husband are daily readers of your blog. We love the language, and of course the canines and the advice. You have made us laugh many times and your jargon has become a household item in referring to people and topic you write about. “

Now that I feel better, we can get to the question. And this matter of trust. The topic is a big one – borrowing to invest.

We have recently been suggested by our accountant to take out a $200k loan from B2B bank. The loan is called an investment loan, registered against the portfolio of securities it is meant to buy. Our accountant is being a bit tongue tied in explaining exactly what these investments are, how are they managed and, most importantly, what are the fees. What we do know is that the loan is prime + 0.5%, and the fees are 1.5% – 3%. The accountant says it’s a combination of ETF’s and Mutual Funds but fails to specify what exactly. He just mentioned he wants us to fill out Know Your Client document, then choose level of risk we are comfortable with. He also is not too keen on discussing this over email, prefers to talk in person in his office.

I don’t like the lack of transparency regarding this situation but my husband is attracted to the idea because the loan doesn’t affect our borrowing abilities (the accountant says it is not registered anywhere). Should we trust him?

So let’s talk about leverage. That’s the term for borrowing to buy something, whether a house or a bunch of financial assets. Sometimes it’s wise. Or not. But always leverage increases risk. If the assets you buy with a loan fall in value, you still owe the money. So leverage can magnify losses just as it can amplify gains (like buying a house with 5% down that pops in value).

Yes, there are good reasons why people borrow money to buy securities. Interest rates are low and money’s cheap. Even better, borrowing costs on an investment loan are 100% deductible from earned income. And lately investors in equities and balanced portfolios have enjoyed gains that are far larger than the interest they must pay. Win, win, win.

But it’s not all ponies. If financial markets fall and funds lose value the investment loan can be called. Sounds like Angie was offered an unsecured demand loan. In that case she’d have to sell the assets purchased, return the money and still owe B2B a pile of cash. Meanwhile, the math might not make sense at all. Prime plus a half equals a loan cost of 4.25%. If the funds being bought come with an average MER of 2%, then even with writing off some of the interest, she’d need to clear 5% to make any money. These days that’s not a stretch, but it might be in the next few years. In any case, is this enough of a potential reward to take the obvious risk?

There are some simple and well-established rules, Angie, for anyone considering borrowing cash to create a portfolio. Like this: you should make a lot of dough and be in a high tax bracket in order to take advantage of interest-deductibility. The advantage of borrowing if your income is just $70,000, for example, is far less than if you make two hundred grand. Second, you need to be financially stable. Good job. Secure income. Able to withstand a loss on the borrowed assets or to have the loan called.

Third is your age – never leverage up if you’re five or even ten years from retirement. There just isn’t enough time to recover if things go squirrelly. Fourth is the portfolio – quality assets only, highly liquid, suited to your risk profile and conservative rather than speculative. Fifth, don’t even contemplate borrowing to invest if you can’t ignore downturns, volatility or the next Trump tweet. Selling into a storm is always bad, but if you bail on a leveraged portfolio, making paper losses real, it really sucks. Finally, only do this if you already have a solid portfolio with your TFSAs brimming and RRSPs topped up.

Now, the accountant. Where did you pick this guy up? In the washroom at a desperate Tony Robbins wealth-building seminar?

Accountants are seldom licensed investment advisors, nor should they be pimps for an outfit like B2B, nor collecting trailer fees from mutual fund slingers. If the above conditions don’t apply to you, this guy shouldn’t even be suggesting you borrow money to buy mutuals. Moreover, determining what assets are appropriate comes after you’ve described your risk tolerance and goals, not before. Anybody flogging funds should present a plan and make sure you understand there’s no interest-deductibility for stuff that goes into an RRSP or a TFSA. Plus, the securities acquired should fit in with existing assets, your pension plans, real estate, family obligations and time horizon.

Leverage is a big deal. Trust is bigger. This fails the smell test.

Run, Angie.

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September 10th, 2019

Posted In: The Greater Fool

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