Most Canadians already use leverage to reach their financial goals without even knowing it. One of the most common forms of leverage that an investor will access is a mortgage. With that being said, leveraging your investments without fully understanding the concept can lead to missed opportunities to grow your wealth.

In this article, let’s explore the basics of leveraged investing, beginning with a simple definition.

Key takeaways

• A mortgage is one of the most common ways Canadians use leverage
• Your leverage ratio decreases over time as you build equity in your home
• Rebalancing your leverage periodically is important to keep your financial goals aligned

What is leverage?

Leverage refers to the borrowing of capital, in order to invest and earn a return. Utilizing leverage enables investors to potentially achieve higher returns than they could have otherwise, but also exposes them to additional risks.

While it is true that many people take on a mortgage without fully understanding the concept of leverage and when to use it, when utilized effectively, it can greatly increase the returns of a portfolio. A mortgage is not only a means to purchase a home, but also potentially one of the most effective ways to access leverage. Even if you can afford to buy a home without taking out a mortgage, it's often more profitable to borrow the money instead and invest your capital elsewhere.

When and how to use leverage ultimately boils down to a straightforward calculation. If the expected return on your investment is higher than the cost of borrowing, leveraging is generally a good idea. However, there is another huge factor to take into account: the risk of your investment returning lower than expected. Let's explore some example scenarios and discuss the pros and cons of leveraged investing.

How to leverage real estate 

Leverage can be accessed through various means, from a line of credit to a credit card. Borrowing against the value of a home is one of the most affordable and simple options for the average investor to access leverage. 66.5% of Canadians own a home, making borrowing against its equity a convenient way to access leverage. More importantly, this is also the cheapest form of financing that most investors have access to. When a loan is backed up with a physical asset like a home, lenders are able to offer better financing rates to borrowers.

This is because the lender is assured that they can recover their funds through the sale of your property, even if you default on your loan.

Investors can tap into their home equity by refinancing their mortgage or by getting a Home Equity Line of Credit (HELOC). 

With that in mind, let’s identify why an investor would want to utilize leverage, other than the ability to access additional capital.

The benefits of using leverage

• Amplified returns: Any returns you make above your cost of borrowing is newly generated profit since you will be using the returns to both pay the cost of your loan, as well as your own pockets.
• Improved cashflow: If you invest in a high yield investment that is above your cost of borrowing, you can increase your cash flow. For example, if you invest $10,000 into a 9% yielding investment and pay 4% to borrow, each month you will generate $75 in income and owe $33.33 in interest, which is a net monthly profit of $41.67 to you. (ignoring tax).
• Increased investment opportunities: By having access to more funds, you may be able to access investment opportunities that would otherwise not be available to you. For example, some investments may require a minimum capital requirement that you wouldn’t have access to without borrowing.
• Taxable income reduction: If you are investing your funds in tax shelters like a TFSA, your returns are tax-free. However, the interest you use to invest can typically be used to reduce your taxable income, which means your effective cost of borrowing should be viewed after tax. For example, if you borrow at 5% and you pay a 40% tax rate, your after-tax cost of borrowing is 3% (5% x 60%). This is because interest is usually a deductible expense on your tax return. For example, real estate investors deduct the interest payments of their mortgage from their rental income. To learn more, we recommend speaking with an accountant or other tax professional.

The risks of using leverage

In the event you’re dealing with a risk-free investment, it’s a relatively simple calculation to decide if using leverage is the right move, However, the return of some investments are not guaranteed. If you’re investing in something like a GIC or a high interest savings account this isn’t an issue, but if you’re investing in a volatile asset like equities it’s a different story. 

The biggest risk of using leverage is if your investment returns less than the cost of borrowing, you’ll end up with a shortfall you need to make up for. If you’ve borrowed more than you can afford to pay, you could face serious losses if your investments don’t turn out how you hoped.

Here are some of the other risks of using leverage:

• Amplified losses: If your investments have a loss with leveraged returns, you will have to make up those losses with your equity. If your portfolio has large enough losses where your equity is not enough to cover it, you may have to liquidate other assets to cover the losses.
• Worse cash flow: Investing in an income-producing portfolio to earn excess returns may not materialize as planned if those investments delay or cancel their distributions/dividends. You would then be stuck paying interest on what you borrowed without any income to offset it. 
• Maturity risk: Depending on the terms of your loan, your lender may be able to force early repayment under certain circumstances. If this happens during a downturn, you may then be forced to sell assets at an inopportune time and recognize losses that you otherwise would have avoided if you weren’t forced to sell.

To mitigate these risks, it’s important to carefully review your portfolio and financial situation, preferably with a financial advisor, to make sure you aren’t over-leveraging and are doing proper risk management.

The risk of leverage scales massively with the amount you borrow. If you manage your leverage effectively, even in the worst case scenario your losses will be limited. On the other hand, using leverage recklessly can lead to bankruptcy, which is why it’s key to not over-leverage.

What is over-leveraging?

Over-leveraging refers to borrowing more money than you can afford to. Of course, if your investments return what you hoped this wouldn’t be an issue, but unless you’re investing in something with a guaranteed return, there is always the possibility that you will need to make up for a shortfall.

An example of over-leveraging:

Let’s use an exaggerated example to illustrate the point: Imagine you are able to borrow $1 billion and your cost of borrowing is an even 0.00%. You’re offered an interest-free loan with a 30 year amortization. Now let’s say you decide to invest that into a market index fund. 

Unfortunately it’s October 2008, and your investment crashes 40% over the next year, netting you $400 million in losses. No worries, because it wasn’t your money and you borrowed it for free, right? Well, you still owe the lender $33.3 million towards the principal of the loan, and liquidating your investment will lock in those losses. This example illustrates how even an interest-free loan can end up with you in a very bad situation if you over-leverage. 

On the other hand, If you were already a billionaire and could have paid off the annual $33 million while you waited for the market to recover in 2014 you wouldn’t have made a bad decision, so it’s important to take your own financial situation into account when determining what the right amount of leverage is for you.

Leverage in action:

Let’s imagine you’re nearing retirement with a paid-off home valued at $1,000,000. You talk to your mortgage advisor and find out you qualify for a HELOC of up to $800,000 at 4.50%. 

You have enough liquid assets that you can afford to pay some of the interest payments, even if your investments are volatile in the short-term. You’ve heard of a mortgage investment fund that is advertising 9.00% returns with a minimum investment of $50,000. You decide to borrow $500,000 in the form of a HELOC, invest in the mortgage investment fund and net around $22,500 annually. You’ve now leveraged your home equity to generate passive income with minimal effort and relatively low risk.

Of course, like previously mentioned, the decision whether or not to use leverage will depend heavily on your financial situation, your cost of borrowing, and what you plan to invest in. We recommend you discuss with a financial advisor before you make a big decision like taking out a loan to invest.