Continuing Education for Financial Service Professionals
Leverage: It’s Dollars and Sense
Leveraging: It’s Dollars and Sense
Copyright © 2015 CLIFE Inc. All rights reserved. Any reproduction of parts or all of this book and its contents by any means electronic or mechanical is prohibited.
The information in this course is provided for educational purposes only; it should not be construed or interpreted as providing advice. Agents and advisors should always seek guidance from their principals and compliance experts in regards to informing themselves and others about details of the products they sell and other considerations of their business.
We welcome all feedback and suggestions for additions to the book. Please send your comments to info@clifece.ca. CLIFE INC. 1595 Sixteenth Avenue Suite 301 Richmond Hill, ON L4B 3N9 www.clifece.ca
Leveraging: It’s Dollars and Sense provides a continuing education credit upon satisfactory completion of an online test. Please see the website for details or email info@clifece.ca.
Table of Contents Introduction
4
What is Leverage?
5
Tax Deductibility and Leverage
8
The Risks of Leverage
12
Conflict of Interest and Disclosure
17
Sources of Funding for Leverage
21
Life Insurance and Borrowed Money
24
Suitability Issues
26
The Exit Strategy
33
Ten Factors Needed for Successful Leveraging
35
A Reminder
36
Introduction -
The purpose of this course is to explain leverage in plain English and not get bogged down in the math of the subject. We want to show the financial side of leverage and the sense of it. This course intends to broaden the understanding of leverage to get advisors and their clients “on the same page.”
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Using plain English to explain this challenging subject is only intended to expand your understanding of the risks and suitability issues of leverage. We do not want to make the concept of leverage sound so simple that even those for whom leverage is unsuitable are prepared to “buy in,” because they think they “get it.”
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One of the key concepts underlying leverage is that it is not suitable for all investors --- that includes those who cannot understand its principles including how it works and its risks.
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However, let’s not hide those risks behind a veil of mathematical formulae and jargon. Let’s rely on good old plain English to explain leverage. Then, investors who choose to use leverage do so with a full and clear understanding of their decision and its potential outcome.
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As once stated by Chris Blunt, VP of New York Life Investment Management, “Good financial advisors often earn their pay through the things that they help their clients not to do.”
What is Leverage? -
Leverage is when an investor borrows money to invest. The result? --- he has more to invest and the returns are his to keep.
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The concept is based on that of a lever: a lever does the work of lifting a heavy object for you --- one that you would never be able to budge on your own.
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Therefore, leverage allows you to increase a sum of money to a higher value than you could do by yourself.
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The return to the investor is: total value of the investment minus the loan = the return
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However, it is not quite so simple as this equation would make it appear because the loan both incurs an interest expense and that interest expense may be deductible from income tax. Emphasis on “may�! More on this sticky issue later.
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Anyone who has ever borrowed money is very aware that loans are comprised of their principal and their interest charge. When it comes to a loan for leverage, both the principal and the interest must be accommodated in the leverage results.
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Therefore, there are two aspects of leverage that must be considered: 1. The eventual payback. The sum received as proceeds of investment must be equal to or greater than the loan principal. This permits the investor to repay the principal without having to make up for a shortfall in the amount of loan from personal funds.
2. The after-tax investment return must exceed the after-tax cost of interest. Otherwise, an investor could have a positive investment return but still lose money! -
Mortgaging a property is one very common form of leverage. However, it is not “true” investment leverage because the mortgage interest cannot be deducted from tax. However, it serves to illustrate very well how a loan levers savings. Example of successful leverage: Jack and Joan have $25,000 saved as a downpayment on a home. They agree to purchase a home at a price of $385,000. They borrow $360,000 from a bank at 3% interest. At the end of five years, they sell the house for $410,000 and their mortgage is $296,283. Their return is: 410,000 – 296,283 = 113,717 They successfully leveraged their $25,000 into $113,717.
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Even an investment as seemingly safe as real estate can be disastrous from a leverage point of view as the following example illustrates: Example of unsuccessful leverage Jack and Joan have $25,000 saved as a downpayment on a home. They agree to purchase a home at a price of $385,000. They borrow $360,000 from a bank at 3% interest. Two years later, they divorce and the value of the property is to be divided equally. However, real estate values in their city have plunged since they bought. Their home is worth $340,000. The mortgage is about the same. Their return is: $340,000 – (340,000 + 25,000) = -25,000 Jack and Joan find that once their mortgage is repaid they are left with a total loss of $25,000. In this case, the $25,000 has come from their own pockets; they
have lost their downpayment. If the mortgage had exceeded the selling price, Jack and Joan would owe the bank the difference. Ouch.
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