Taking advantage of real estate's rise
If you’ve owned a home over the last few years, real estate has proven to be a stellar investment. Perhaps it’s time to consider a strategy to take advantage of the equity you’ve built up to grow your wealth for tomorrow or help enrich your lifestyle today.
There’s no doubt that home ownership in the Lower Mainland has been a solid, long-term investment with our beautiful environment, strong demand and international presence.
However, despite the positives, there are risks. The real estate market’s price performance since 2001 has been far above historical averages. Affordability remains stretched, leaving buyers vulnerable to higher interest rates. Changes to mortgage rules that eliminated amortizations beyond 30 years could push first-time purchasers further out of the market. And as the financial crisis taught us, even popular Vancouver can experience sudden and sharp price drops.
With real estate prices trending higher, it might be tempting to think of home ownership as an easy route to building a retirement nest egg. But as with any other asset, having too much of your net worth tied up in your house can be risky.
Unlocking your home’s value
One way to take advantage of your built-up home equity is through what’s known as “leverage” or borrowing to invest. Leverage, when used wisely, can help you better diversify your assets or provide income to enhance your lifestyle.
Carrying debt will often hold you back in growing your wealth, but using leverage is different. When you borrow to invest, the interest charges you incur can be tax deductible. And the higher your tax bracket, the greater your savings.
Dollar for dollar, deducting interest expense through leverage creates the same tax savings as contributing to an RRSP, regardless of tax bracket. Investing the borrowed funds in tax-preferred choices like dividend-producing investments can further enhance your returns.
For most people, a practical way to get started with a leveraged investment strategy is to first establish a home equity line of credit. Secured by your home’s value, this line of credit can offer lower borrowing rates and more flexibility than alternative home equity options like reverse mortgages.
How leverage works
When you’re using borrowed money, you’re putting more capital to work than you otherwise could. For this reason leverage can lift your total investment returns beyond what would be possible when not using borrowed money.
Here’s a simple example.
Let’s say you borrow against your home equity and still invest $4,000 of your own cash. Assuming you borrow $100,000 at an annual loan rate of 4% and place it in an investment that generates a 5% return annually. After paying $4,000 in interest out of your returns, you would have pre-tax $1,000 which is five times the amount of income you would have generated if you just invested your $4,000 at 5% and received a total annual income of $200.
Let’s consider a couple of sample scenarios that outline how homeowners can use their home equity to better meet their financial goals. The following scenarios are for illustrative purposes only and assume a constant cost of borrowing and rate of return. Everyone's situation is unique, so it's important you consult your financial advisor for specific information if you are considering leverage strategy.
Retirees Sandra and Tom: Creating extra income
Sandra and Tom, both 67 and recently retired, have had a change of heart. Their plan all along was to sell the home they’ve lived in for the past 35 years and downsize once they left the workforce.
But now with major renovations behind them and a lifetime of memories, the couple has fallen in love with their West Vancouver home all over again. Sandra and Tom were counting on the sale to cash in some of their home equity to create income - now what?
After meeting with their financial advisor, Sandra and Tom decide that starting an investment program using conservative leverage would be an effective way to build their retirement income without having to sell their home.
Debt-free, the couple has significant equity to draw on. A recent appraisal set the value of their residence at $1.5 million.
After tallying up the income they’re receiving from RRIFs, pension plans and non-registered assets, they’ve determined how much additional income they need to meet their lifestyle goals.
To make up the shortfall, Sandra and Tom follow their financial advisor’s guidance and borrow $150,000, or 10% of their home equity. This lets them create a leveraged portfolio of high-yield dividend-producing investments paying 6%. Because of their strong financial position, the couple qualifies for a home equity line of credit at a preferred loan rate of 4% (prime +1%). This interest rate is variable, and since Sandra and Tom will be making interest-only payments on the leveraged amount, they must be aware of the inherent interest rate risk.
Because they are able to achieve an investment return above their loan rate, Sandra and Tom will generate an extra $3,000 a year right off the top by borrowing against their home equity. But there are additional tax benefits to this strategy.
First, the $6,000 in interest paid annually on their line of credit is tax deductible. This means that in their 40% tax bracket, Sandra and Tom will be able to reduce the net cost of their loan by $2,400 annually.
And because they’ve chosen an investment portfolio holding dividend-paying investments from eligible Canadian corporations, their taxes will be further reduced through the dividend tax credit. Rather than paying 40% tax as they would on income from interest-paying investments like term deposits or bonds, the tax rate on their dividends will be closer to 17%. This results in taxes of $1,530 versus $3,500 for interest income, giving them an extra $2,000 a year in after-tax income.
Combined, the investment return and tax savings will result in a total annual benefit of $3,870 in this scenario.
$9,000(dividend income) - $1,530(dividend credit) - $6,000(interest cost) + $2,400 (tax savings from deductible interest) = $3,870(total net benefit).
While a leveraged investment strategy can clearly help Sandra and Tom with their income goals, their home equity line of credit will also give the couple important flexibility if they have arranged for a borrowing limit that is higher than the initial amount they used for investment purposes. For example, they can draw extra funds for unforeseen expenses like a new roof or medical treatment without having to cash in their investments. Selling prematurely might trigger capital gains and extra taxes, or, if the market’s down, cause the couple to lose money. Instead, by accessing their line of credit when markets drop, Sandra and Tom can cushion their cash flow through the rough spots. Later, they can pay back the added debt and the original leveraged amount by selling investments when they choose, not because they’re forced to.
Professionals Jennifer and Kyle: Building for the future
Is leverage right for you?
Leverage can ramp up your gains, but it can also magnify your losses. For this reason leveraged investing is not right for everyone. Here are some factors to consider:
Be honest about your risk tolerance. Using leverage does mean making regular loan payments. When Jennifer and Kyle bought their home 10 years ago, they had one thought in mind, to pay off the mortgage as soon as possible. Their efforts, a high household income and a healthy run up in home prices have let them build an impressive $750,000 dollars in home equity.
Now in their mid-40’s the couple’s all-out focus on debt reduction has left their investment portfolios neglected. Complicating matters, their company pension plans have limited the couple’s RRSP room and the amount they can contribute to their own RRSPs.
How can Jennifer and Kyle use their home’s value to kick their retirement savings strategy into high gear?
With many years remaining until retirement and healthy incomes, Jennifer and Kyle can afford a more aggressive approach to leveraged investing. After reviewing their current situation, risk tolerance and retirement goals with their financial advisor, the couple decides to borrow $200,000 against their home equity. This will let them build a tax-efficient retirement savings plan outside of their RRSPs. To fund their investment strategy, Jennifer and Kyle are able to secure a home equity line of credit at a 4% interest rate. They can choose to pay down the line of credit principal while they are in their peak earning years, or elect to make interest only payments.
With a long time horizon, the couple’s leverage strategy can focus on the higher growth potential of equity investments. Choosing investments that generate capital gains instead of income can be tricky when using leverage. The couple’s financial advisor helps them carefully select an investment mix with income-producing investments that will stay on side with tax rules and keep their interest expenses tax deductible.
Assuming they are making interest only payments on their home equity line of credit, Jennifer and Kyle expect to grow their leveraged portfolio by 6% (4% dividend income + 2% capital gains) a year. The result is a tax-preferred net annual cash flow of $2,160 from the dividend income which can continue to grow in their portfolio or in other investment products. In this scenario, Jennifer and Kyle also accumulate capital gains of $97,189 added to their retirement savings by age 65, thanks to their leveraged investment strategy.
- payments. Is your income stable and deep enough to handle your investment loan, while still paying your everyday expenses and other debt obligations? Also, remember interest rates are hovering around record lows. Would you be able to handle a sudden increase?
- How long is your investment horizon? If you’re using leverage to build your wealth through equity investments, it’s important to give the strategy enough time to ride out market cycles. Think 10 years at a minimum.
- Are you in a high tax bracket? The higher the tax bracket, the better when it comes to benefitting from leverage. Ask whether the savings from leveraging in your tax situation will be worth the effort, and the risk.
Under the right circumstances, a leveraged investment strategy can be an effective tool to unlock your home’s value. Before moving forward it’s important to consult your financial advisor to structure your plan properly, not only to stay within your risk tolerance but to achieve your objectives tax-efficiently.