Your mortgage: an investment leverage
August 12 2016
What you'll learn
- What is an investment?
- How does financial leverage work?
- Who can benefit from financial leverage?
How can you transform debt, such as your mortgage, into a sound investment? How can your loan be used as financial leverage to increase your net worth?
Above all, it’s important to understand what is considered an investment. An investment is an asset that generates recurring revenues or that increases in value over time and surpasses the capital sum initially required.
However, in order to realize capital gains, you’ll have to calculate everything—and we mean everything! In real estate, in order to have a clear picture, you need to take into account welcome taxes, property taxes, school taxes, commissions for your real estate agent or advertising costs, renovations, discharge fees, income taxes…and inflation!
To top it off, you also have to compare this type of investment with others that entail no risks. After all, why go through all the trouble if you can get a guaranteed investment that will offer similar returns?
An invention that revolutionized mechanical engineering—and finance
A mechanical lever is an ingenious—and very old—invention. It most probably even preceded the wheel! When you were a child, you may have experimented with levers. Using a plank of wood or a huge tree branch, you may have tried to lift or move a rock, brick or any other heavy load. All you had to do was push down on the other end of the piece of wood!
A mechanical lever is therefore a tool used to amplify an input force to quickly provide a greater output force. A financial lever provides the same effect; it amplifies the volatility of an investment and reduces the time it takes to achieve your goal.
For example, if you purchase a $400 000 home with a $80 000 down payment and have a $320 000 mortgage, you could quickly resell the property for $500 000. That’s a $100 000 profit. Compared with your initial capital of $80 000, you have made a gross profit of 125%. If someone else used his/her own money may have also gotten a $100 000 profit; however, based on his/her fixed capital, the gross profit would have only been 20%.
In this example, the $80 000, matched with your good credit score, represents the “lever” that will enable you to “raise” $320 000 in capital and have $400 000 that enables you to get proportional gains.
Is the era of easy gains over?
For the past 15 years, thousands of Quebecers have achieved considerable gains with minimal down payments and selling several properties. They used their ability to borrow to put their capital to work for higher benefits. By “borrowing in order to invest” The Canada Revenue Agency and Revenu Québec enable you to deduct the interests used to generate revenues or taxable gains. It is important to speak to a tax expert or chartered accountant to understand all the ins and outs when deducting financial and amortization costs.
There are a wide variety of ways to use a financial lever to your advantage. If you are mortgage-free, you could refinance your home to buy a secondary residence that you would renovate and resell. You could also buy a cottage or condo in a highly popular tourist area and rent it in any season. You could also invest in a duplex, triplex or other income-generating property.
It’s thanks to a few smart moves that savvy investors were able to build or acquire huge multi-unit lodgings.
The more time you dedicate to this type of investment, the more likely you’ll get a handle on the nuances and ways you can increase your net worth. Contrary to stock market speculators, who take chances and base their decisions on approximations, an intelligent property investor calculates risks and doesn’t miss any fine details.
Another aspect to consider is that real estate follows economic cycles; the interest rate fluctuations and demographics of a country can great affect the housing market. What’s more: household debt ratios and an aging population can overturn yield curves. Although housing prices continue to increase, the market can stagnate and cause major drops. The leverage effect amplifies both gains and losses.
Don’t forget liquidity risk
At the end of a market’s cycle, the most difficult risk to evaluate is liquidity risk—or the possibility that you reach a financial impasse without the ability to quickly sell your home. For example, you may have a hard time finding some to rent out your place, securing capital to carry out urgent repairs, pay off your required minimums if interest rates climb, etc. Liquidity risks force you to sell your property—sometimes at a loss.
In a real estate market that has been properly evaluated and fire sales are unlikely, many investors opt to limit their liquidity risks. They’ll use their ability to get a loan based on their real estate assets and turn to the securities market. Therefore, instead of buying houses, cottages and condos with the money they borrow, they build a portfolio of investments comprised of funds, bond funds, ordinary shares, dividends and other stock options.
The main advantage of this strategy is that you can resell these investments in (almost) a blink of an eye. No need to call upon the services of a notary or pay municipal taxes, inspections, discharge fees, etc. Furthermore, in these circumstances, your interest is deductible.
Federal and provincial agencies in Canada estimate that the “expectation of income” is reasonable and deem that financial investments can be deductible. With a diversified portfolio, you can ensure a regular monthly income. Depending on the amounts you receive, the payout rates hover around 3% to 7%.
A financial leverage strategy is not for everyone. Above all, evaluate your tolerance for risk and economic volatility. Rely on the expertise of a qualified broker, savvy accountant, and wealth management advisor.
- Calculate your gains by taking into account all of your expenses. Then, compare your potential gain with the ROI of a secure investment.
- Smart investors calculate their risks and look into all the nitty gritty details.
- Carefully evaluate your risk in case you need in case of a liquidity shortage.