Leverage – Is it Always Bad?

This one won’t be long, I think. That said, I always think that when my fingers begin to peck away on the keys. 

Why this topic? Well, it seems appropriate given how I notice how many of the FI blogs focus on debt as the enemy and something we have to conquer at all costs…

While I do notice some of them focus very heavily on ‘bad debt’, it also seems to permeate into home purchases, vehicle purchases, etc., not just the evil credit cards or consumer loans. 

Don’t get me wrong, since my wife and I graduated University in 2001, we have had zero to minimal balances on any interest bearing credit card (more on that to follow) and we’ve paid zero to minimal interest on car loans. 

That said, we’ve levered ourselves in a number of areas, where I feel we had to, and in other areas where I feel it was beneficial to. 

First, we live in an area that has the highest housing costs in our Country, which means that it is very improbable that we would ever be able to afford a home without a mortgage, specifically if we are attempting to own a home within a reasonable commute to work; as such, we’ve utilized leverage to purchase our primary residence, multiple times. 

When we returned to this Province in 2007 we bought an amazing home in a great location; however, it was an approximate 45-60 minute commute to work, in both directions, with the only positive being that commute was public transit at minimal cost. However, it did mean 2 hours away from family and working out each day and when combined with long work hours resulted in less than ideal physical and mental fitness. 

In 2010 we purchased a new home in, to me, a super desirable area to live that was well below my impression of market value, as a result of silly negative public sentiment. To purchase the home, which was a presale, we needed to put a down payment of 20% ($140,000); though, most of our equity was already tied up in our existing home, which made this difficult.  The biggest benefit of the acquisition, for me, was that it allowed me to be within a 10 minute commute of my work and tomorrow I will start to actually ride my bike to work for this short commute, which saves a lot of time for family, physical and mental health.

My wife and I had to both (a) improve our spending, though it still wasn’t good enough – not to the Mustachian levels of MMM readers, and (b) find alternative sources of financing in a clever way. My wife was able to source this out in the form of MBNA zero rate credit cards, which charge a 1% transaction fee (thus, a 1% interest rate). The interesting part about these cards is that generally each year they will allow you to apply for a new one and transfer your existing balance to the new card, at a zero balance again, for the 1% fee. In that way, we were able to raise ~ $50,000 of the $140,000 required through these cards and an additional $90,000 through savings. The key with cards like these is to always ensure that you have sufficient capital, such as a LoC, to repay them when they come due, in order to avoid the potentially debilitating interest cost they would charge, which backdates, if you miss the payments. 

Once this home was completed ~ 1.5 years ago, we sold our past home for a cost that was slightly more than the purchase price + transaction fees, though not material and put our additional equity into this home and paid off all credit card balances and lines of credit; though, we did maintain the MBNA zero interest cards to bolster investment balances and ensured sufficient LoC space to pay off on due dates. 

The big benefit that we picked up in acquiring the home was that it provided an immediate increase in value as it’s appraised value was $368,000 higher than what we paid for it back in 2010, confirming what I’d expected. That said, how does $368,000 in increased value help us if we aren’t moving? Also, how does it tie to the above post title? 

Well, in Canada we have a version of 401(k) called RRSPs, which allow us to invest pre-tax amounts that will grow tax free until we withdraw the funds, which will be taxed at that point. While I had a ton of unused contribution room from my working years (all my equity went to home purchases), I did not have sufficent cash to invest. Also, I had great opportunities at work for eligible RRSP investments in the 10% to 15% range, as well as non-RRSP investments in the 20% return range, all attractive investment targets, and all well above the cost of borrowing against our home for Prime + 1%, when Prime is 1.75%. 

To that end, we talked to TD Bank, which provided a great service, and secured a HELOC on our home allowing us to borrow an additional $250,000 against our home and I took on an additional loan, faciliated through work, for an additional $100,000, allowing me to invest $350,000 into the above investments. 

Of that $350,000, $85,000 went into the RRSPs, which provides a return on our taxes of ~ $37,500. As we expect the $350,000 to be outstanding for 18 months, assuming interest at 4% would be a cost of funds of $21,000 so the tax refund from the RRSPs will repay the interest cost for the full $350,000 with an additional $16,500. The $265,000 at a 20% expected return will generate $79,500 over the 18 months we expect the investment to be outstanding. At the culmination of this investment, I would be able to repay the full principal of the loan (I likely won’t do that), including the amount that went into the RRSP, and have $11,000 additional. This will allow us to grow our net worth by $96,000 + $15,000 (approximate expected RRSP return) = $111,000 in 18 months, which I would not be able to do if it weren’t for leverage!

Is there risk, of course there is risk. Some of that risk is mitigated for certain of the investments; though, that is something I won’t go into details on the blog. Being in a city that requires such a disproportionate amount of your income and net worth to be tied up in your home, leaves me with a feeling that without taking on such risk, or moving to a much lower cost living area, that it would not be feasible for me to reach FI. As such, we will continue to bear these risks and ensure that we have sufficient income to meet our debt service coverage and disposable assets that we could liquidate, if required, to cover the repayment of principal costs. 

As you may be able to tell from the above, I clearly believe there are times when leverage is not our enemy, but rather our friend, and I will seek to employ low cost leverage whenever and wherever I am able to take advantage of it to grow our net worth and reach FI sooner. 

That said, both my wife and I are admantly opposed to any form of high cost leverage and like MMM and most financial bloggers, believe that high cost debt (credit card, consumer loans) etc. are the scourge of the financial world and result in so many people being underwater and ever being able to get out from under it. 

A couple of years ago, a close family member of mine was in a position of determining whether to declare bankruptcy or not. The amount of debt that was outstanding for consumer loans and credit cards was simply debilitating. When I said, how could you have bought x, y and z with this much debt??? The reply was, well you have a nice TV, isn’t that the same? I shook my head in exasperation – no silly, we only buy a TV or other item if we are paying in cash, we do not buy on debt – perhaps a car, but only if they give us a 6 year zero percent interest financing fee…that I might do. He was super surprised at this and didn’t realize that. 

In the end, for that situation, my wife was able to work a budget out for them that was rather quite Mustachian in nature and actually allowed for them to pay off their debts and return to normal living in a much saner, safer manner; however, it was not to be. They looked at what we’d prepared for them and determined it was too draconian and impossible to live that way and so chose the route of bankruptcy, which unfortunately is not the route of lessons learned and I fear is always doomed to replace itself. 

Well, what started off as a ‘hey, leverage is great’, ended with a ‘leverage can be a horrible weight on your shoulders’ message. The key, for you the reader, and for me, is to consider (1) what is the cost of the debt – can you service it? Is the rate reasonable (sub 5%); (2) What is the purpose of the debt? Is it to grow your personal net worth? Is it for life betterment and future financial gain? (3) Do you need to do it today or could you save for a period of time and avoid the debt? If it’s high cost and is not a life-threatening payment, then don’t make it. If you don’t need it, then don’t buy it, etc. 

On the other hand, if it’s low cost and is intended for investment that will increase your net worth or allow you to achieve FI sooner, then I believe there is a time and place for leverage to be your friend. 

What do you think?