December 2005/January 2006: by Dale R. Berg

Good Debt, Bad Debt

We live in a world of mortgages, credit cards, lines of credit, and demand loans. Debt is essential in today's economy, and in many ways, it is essential to today's businessperson to be able to stock inventory, pay salaries, and buy buildings. Debt used properly can be the salvation and lifeblood for many businesses; it can also be the single contributing factor to bankruptcy. We therefore can conclude from those comments that there are two types of debt, good debt and bad debt.Good debt is where you can tax deduct the interest expense, and the funds borrowed are used to invest into your business, or a number of businesses that will increase in value. Bad debt is non-deductible consumer debt that is used to purchase things that will likely drop in value, and the after tax interest charge can range anywhere from 15-35%.

As previously stated, many business owners currently borrow money to grow their business. But what about investing your borrowed dollars into other peoples businesses, and why on earth would you ever want to do such a thing? The simple answer is to increase your personal wealth, or turn some of your bad non taxdeductible debt into good tax-deductible debt.

Borrowing money to invest into company stocks or equity mutual funds is a concept called leveraging. Webster's dictionary defines leverage as "influence, power to accomplish something, or advantage." The definition sounds very interesting, and extremely enticing, but in order to properly evaluate if conservative leveraging is right for you, we must look at all the pros and cons of doing so. This was a very lucrative, and wonderful concept during the 1990s when equity markets were returning 15% compound rate of return each year. But what about today where most market analysts predict equity markets to return 7-9% to investors?

Does it make sense to borrow money at 5% to achieve a 7% rate of return? The answer is yes; it makes a lot of sense. In a 40% tax bracket, and assuming the 7% rate of return was the result of a combination of dividends and capital gains, a $50,000 leveraged account would be $15,400 ahead of the savings account over 10 years. In reality, the breakeven point between the interest charged on your loan, and the rate of return you achieve on your investment is somewhere around 60% of your loan rate after 10 years. In other words, if your loan rate is 9%, you need to generate 60% of that loan rate or 5.4% investment rate where it would not have mattered if you saved the money each month, or paid interest costs on a loan.

If this sounds interesting, you need to know some of the mechanics of setting up a leveraged account. First and foremost is setting up the loan. The best way to do this is by having it secured by other investments, the equity in your home, or the leveraged account itself. This will dramatically reduce your cost of borrowing since banks like security, and penalize those who don't have it with higher interest costs. Once you have access to the funds, you need to select your investments. Equity mutual funds, equity segregated funds, and common shares have been approved by Canada Revenue Agency as qualified investments, therefore borrowed money to invest into these products will create interest deductibility. Since 100% of your investments will be equity based, it is strongly advised you seek the professional advice from your financial advisor, or stockbroker before purchasing the securities.

Interestingly, many people have current non-deductible debt that could very easily be restructured into tax-deductible debt by using leveraging. This procedure is commonly called an investment swap, and could favorably impact the cost of borrowing, as well as future wealth creation. Example: Jim has $20,000 of Canada Savings bonds, and a $25,000 car loan. He should cash in the $20,000 of CSB's, pay down his car loan, then borrow $20,000 to purchase some equity mutual funds.

Jim has just created a tax-deductible interest only payment for the investment loan, and has paid down a depreciating asset; while at the same time exchanged it for an appreciating asset. Before completing any of the strategies I have mentioned, every investor must fully understand the risks involved.

Leveraging is not suitable for every investor, and for every situation. But if it fits within your financial plan, and you see the benefits after carefully weighing all the risks, it could very well create some nice tax deductions, and add dollars onto your personal wealth balance sheet.

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About the author
Dale R. Berg, CFP, CLU, ChFC, is a Senior Financial Advisor with Assante Wealth Management. He can be reached at 1-877-837-3377 or 306-665-3377, or click to email Dale Berg.

Disclaimer
Please contact a professional advisor to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.

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