In this Part, we look at a more advanced form of Leverage: the "Interest-Only" leverage loan. Not only does it magnify the potential reward even further, it also magnifies the risk involved even further. If you’ve never leveraged before, perhaps you should consider trying the aforementioned version of leveraging (paying principal AND interest) first.
As its name implies, an interest-only leverage is where you take out an investment loan but only pay the interest on a monthly basis. You don’t make regular principal repayments – which means: THE LOAN BALANCE NEVER GOES DOWN! First question: Why would you do this? Most people would take out an "interest-only" loan because they would like access to a larger amount of capital. The loan will have to be paid off at some point though and the logic of the investor is that if they make a better rate of return on the investment than the rate of interest they pay on the loan, then after time they will have a handsome some of money left over AFTER repaying the loan balance in full. Let’s look at an example:
Greg decided that he wants to take out an "interest-only" loan because he wants more money in the market. If we stick to his $1000/year cash flow constraint then we need to do some simple math to figure out how much of a loan $1000/year will support. So let’s assume that the prime rate is 6% – since an investment loan is secured by a portfolio of securities which should appreciate over time, you can probably get your interest rate on the loan AT PRIME. So if Greg only needs to pay interest on the loan, than means he can afford to pay $1000/year in interest. If you divide $1000/year by 6% interest/year you arrive at $16,667 for the loan balance.
So let’s see what happens after the 10 years of 10% return that we’ve been using as an example from the other leverage case studies… By starting with a lump sum of $16,667 after 10 years at 10% average growth we get $43,230. BUT, don’t forget that we still have to repay the loan since we have made any payments towards it – so subtracting $16,667 from $43,230 leaves us with $26,563.
DON’T FORGET: The interest payments of $1000/year are tax deductible if the loan principal is invested inside a non-registered account, so Greg can get back $500/year in tax every year!
Let’s recap from the beginning:
Greg invests $83.33/month ($1000/yr) to his investment portfolio for 10 years, which returns 10% per year. He has $17,531 at the end of year 10.
Leverage (principal and interest payments):
Greg pays $83.33/month for 10 years to support an investment loan of $7,530.89 which after 10 years grows to $19,533. He has also written off $2,469 in interest costs over those 10 years which when multiplied by his marginal tax rate of 50% yields him a tax savings of $1,234.50. Add this to $19,533 and he has $20,767.50 at the end of year 10.
Greg pays $83.33/month for 10 years to support an interest-only investment loan of $16,667 which after 10 years grows to $43,230. After subtracting the value of the loan outstanding ($16,667) from this amount Greg is left with $26,563. He has also written off $10,000 in interest costs which when multiplied by his marginal tax rate of 50% yields him a tax savings of $5,000. Add this to $26,563 and he has $31,563 at the end of year 10!
Don’t lose sight of the fact that I am only showing you the potential upside so far – by no means should you go out and get a leverage after having read this. It is difficult for investors to get a 10% average rate of return for 10 years unless you really know what you are doing, or have an experienced advisor working with you. We have yet to look at the downside numbers, and they will depress you just as much as the upside numbers have made you giddy with plans of how you are going to spend your millions!
Part 5 of the series in Leveraging will look at what can go wrong with an "interest-only" leverage! You won’t want to miss this one…