As interest rates begin to decline by the central banks and cheaper debt becomes available, we’ve noticed lots of conversation around leveraging existing assets to deploy more capital. While properly managing debt can open up opportunities, it requires a strategic approach to ensure you’re setting yourself up for long-term success. To responsibly use debt, it is important that you effectively manage and mitigate risk. . Below, we will cover some general characteristics that should be considered to ensure the responsible use of debt.
Our Instagram has included a two-part series on this topic where Kaz takes you through his thoughts on responsible use of debt on video!
Part 1 – Responsible Use of Debt
Part 2 – Responsible Use of Debt
When consider the responsible use of debt here are a few key characteristics:
Income Producing – A general characteristic of responsible debt is one that has income and cash flow to cover the debt servicing costs. The assets acquired should ideally generate enough cash flow to cover the interest and principal payments. For example, a mortgage for a rental property where the financing costs are lower than rental income. Generally speaking if there is a reasonable expectation of income the interest becomes tax deductible offering a further advantage to savvy investors.
Leverage Opportunities – Using debt to take advantage of investment opportunities that may not be accessible otherwise can be an effective strategy. The use of leverage allows you to invest larger amounts than the cash you have on hand. This would be beneficial when the return on investment is expected to be higher than the cost of capital. Thus, it is important to carefully model the investment and have a reasonable understanding of expected returns before making this decision.
Amplify Returns – Leveraging real estate investments and taking on additional mortgages can significantly increase your returns. You can acquire larger assets with lower equity requirements, but benefit from the full value of the property when it appreciates, and only pay interest on the portion you borrowed. This way, you can maximize your portfolio and take on more investment opportunities. Common strategies to amplify returns are the use of the CMHC MLI select program in Canada and in the United States the use of the Fannie Mae and Freddie Mac loan programs.
Build that Treasure Chest – A major strategy savvy investors employ is to have access to liquidity (near cash resources) to be able to cover their cash position in the event of a need. A common analysis is to list your assets and sources of cash including credit lines or other debt instruments whether drawn or not to adequately understand your resources. There are some investments that can have significantly penalties if withdrawn such as an RRSP and should generally be drawn upon in extreme circumstances.
Any investment strategy has risks and employing leverage even through the responsible use of debt has its risks. We have outlined a few below and recommend having a consultation with a professional advisor such as Finalyze CFO Services before taking on this type of approach.
High Interest Rates and Credit Capability – Those with lower credit scores that may not be able to secure traditional loans/mortgages are generally better off by using lower leverage and focusing on building their assets. Individuals with existing high-interest rate debt may want to prioritize refinancing or paying off these loans before taking on additional investments.
Unreliable Cash Flow – If you have unsteady income or low cash reserves, debt may not be the best option for you. While investments should only be made after careful consideration, it is always a possibility that they may not produce the returns you anticipated. It may no longer be able to cover your loan payments, becoming incredibly risky to take on without a steady income or significant cash reserves to cover these costs. A common mistake that we see individuals make is withdrawing from their RRSP when they have a cash stumbling block, but doing so can impose enormous penalties.
Personal Consumption – Loans for personal consumption that may also have high interest rates should be paid off as soon as possible. This includes debt that finances non-income producing assets, or even those that depreciate. While it may be tempting, this is a riskier use of debt that can negatively impact your financial wealth and take you away from reaching your goals.
The responsible use of debt can be a sound strategy to build wealth and take your portfolio to the next level. At Finalyze CFO Services we have a passion for capital markets and investment strategies. Our clients work with us to determine a sound strategy through our Plan, Raise, and Manage approach to help them crush their goals! Click here to book a free consultation to learn more about how responsible debt can fit into your investment strategy!