Talk about debts, loans and leverages is taboo for many investors. They avoid these things like the plague.
Sometimes I agree; however, the present is not that time.
Currently, anyone can secure loan for five years on a fixed mortgage at an interest of only 2.99%. And if I invest the money in a taxable account, the interests become tax-deductible. After tax, my loan interest goes down to almost 1.6%. So, if I am one with a 46% marginal tax-rate (income range from $136K to $514K in Ontario as of 2014), my after-tax expense is only more than 1.6%.
If you are aware that your cost is 1.6% yearly for five years, what are the chances that your investments will be profitable? What level of risk are you incurring?
One area to begin your search at is the last 991, five-year periods to get some valuable information. Personally, I would look at the wide U.S. market S&P500 starting in January 1926 until June 2013. More than 991 various five-year periods – a new period starting and ending each month – will show how many beat the pre-tax loan cost of 2.99%. Based on an after-tax view, U.S. stock dividends are taxed equally with interest income; however, capital gains are taxed only half of that rate. Perhaps, a good proxy to make the tax balanced would be a five-year return of 2.5%.
Surprisingly, there is a 79% of a chance you would return more than 2.5%, and gaining by borrowing at the current five-year mortgage interests. Certainly not a bad average. Interestingly, there are two quite long periods of success.
From December 1937 to April 1965 – for more than 27 successive years this would have been a sure bet, without any five-year rolling period with a total return less than 2.5% yearly.
After that, from December 1973 to July 1997 – yet another more than 23 years of straight five-year rolling periods with the same yearly total return not more than 2.5%.
Do we expect a new 20-year period soon? That is a possibility. Both long runs mentioned in the past occurred after a harsh recession.
Is there bad news?
The worst five-year era throughout our lifetimes was -6.64% from the period starting March 2004 until February 2009. The last time it was worse than -6.64% was 76 years ago (August 1937 to July 1942).
Assuming someone likes the 79% odds of winning and the fact that the average five-year total return is 9.8%, even if you get taxes and a tiny fee out of the way, we are looking at an after-tax gain at an average of 6%+, when the cost is only 1.6%. It is one tempting wealth-maker. Hence, if someone takes out a loan of $200,000, he will make an average of $50,000 of after-tax profit within five years.
Can we increase the 79% odds to 90%+ while managing a 5% after-tax return?
One possible scenario would be to primarily lock in a gain with just a slight risk involved.
If we loaned on a five-year mortgage, and put 75% into the S&P 500, and put the remaining 25% into mid-range corporate bonds, you could surely reduce your risk of losing your investment.
For example, we have a Corus Entertainment bond that becomes mature in 2020. The bond interest is 4.25%; but you can acquire it at a discount. In truth, its full yield when it matures is 4.69%. Meaning to say, if we assume that Corus Entertainment will eventually pay its bond at maturity, your total gain will be 4.69%. Since your interest cost is 2.99%, then you have an assured 1.7% gain annually. I know that this is nearer to a six-year bond; but it can readily be sold in five years at a price almost at 4.69% yield to sale.
This sort of bond stabilizer can make this approach (or any investment portfolio) incur lower chances of loss.
Other choices can be to augment blue-chip firms with strong Canadian dividends.
One other method would is 60% S&P 500, 20% bonds with a 4%+ yield to maturity and about five-year maturity, and 20% in TransCanada Pipeline, BCE and National Bank.
Put together, these three stocks will give an average dividend return of 4.37%, or 3.1% after-tax – the dividend alone has a 1.5% after-tax bonus over after-tax borrowing costs on the mortgage. Certainly, you take some risks of capital loss on stocks; but these three companies are some of the firms with lower volatility, that is, they have a low potential for a five-year price decrease.
From this discussion, I can confidently say without batting an eyelash: Taking out a loan at 1.6% after-tax and investing in an assorted portfolio for five years is a clever choice, and one that growth investors (who appreciate the risks involved) could do today to build wealth.
Borrowing to play the stock market sounds like a very stupid idea to me.
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