Leveraging is a strategy of using borrowed money to invest. The use of leveraging can be applied to real estate, stocks, bonds, and other investments.
When used properly, it can be an amazing financial tool as it allows the investor to employ a limited amount of money towards a larger investment than would be possible through a direct purchase made with available cash.
Compound Returns. Leveraging allows you to invest more money now, and gets this money working for you right away. The effect of compound returns is much stronger with this strategy and can result in better investment returns over the long term. This may be a great solution for investors looking to get a boost on their retirement savings.
Interest payments may be tax deductible. While the interest you pay on a loan essentially reduces your investment return, interest paid on an investment loan is generally tax deductible. CRA has very strict rules about what types of investments qualify for interest deductions, so it is important to understand those rules in detail.
Boost your effective returns. Leveraging can magnify your returns, both on the upside and the downside.
Leveraging can significantly magnify your returns, both on the upside and the downside. It’s important to be aware of the risks associated with leveraging.
Higher risk tolerance. Due to the risks associated with leveraging, this strategy may not be appropriate for conservative investors.
Borrowing to buy an investment fund has a higher risk than paying with cash because the interest charges on the borrowed funds must be paid irrespective of how well or how poorly the investment fund performs. If the investment suffers a loss, the full amount of the loan must still be paid, plus the accrued interest.
Interest rate risk. The key to successful leveraging is to have your after-tax investment return exceed your after-tax cost of interest. Of course, we cannot predict investment returns, nor can we control rising interest rates.
Margin calls. If the market value of your investment drops below a certain margin, the lender may issue a margin call where you will have to put in more money to make up the difference. To help minimize this risk, the loan can be secured with another asset.
Taking out a loan to purchase investment funds will increase your Debt Service Ratio, which may impact your ability to borrow money for other purposes.