A few weeks ago I was asked to take part in a personal finance expert sort of panel over at Boomer and Echo, AKA the only adult man in the world who willingly spends time with his mother when he isn’t trying to bum smokes or to sucker her into taking care of his kids. You’re a bigger man than I, Robb.
Robb ended up asking 15 of us what our opinion was on borrowing to invest. He “got” a letter from a “reader” (fact: 99% of those are made up) who was thinking of borrowing money at 3%, buying Canadian Oil Sands at an 8% yield, and pocketing the difference. Naturally, a good 80% of the 15 experts he chose to interview thought it was a bad idea.
The big negative, of course, is risk. If you have $20k to invest and you borrow an additional $20k, things can go very badly if you’re wrong. If oil goes down to $50 a barrel again and Canadian Oil Sands has to cut the dividend, that’s gonna turn out very badly. Hell, if oil stays at $50 for a year, Canadian Oil Sands isn’t just cutting the dividend. It’s toast.
In that situation, your $40k original investment might only be worth $20k, plus there’s no dividend left to pay the interest. Thus, borrowing to invest can be a pretty easy way to lose your entire principal and eventually get you into the poorhouse.
Sorry, I lapsed into one of those debt is evil guys for a second there.
So I understand the thought process of not borrowing to invest in one individual stock. Portfolios exist for a reason, even if I think that owning 40 stocks is too many. Diversifying the risk away from one stock is good.
But what about borrowing to invest in many stocks? Or a rental house/principal residence with an additional suite? Or to lend out to many people at a higher interest rate? There’s certainly a case to be made about that.
Let’s back up for a minute. There are two ways to get rich. You can:
1. Increase your income
2. Decrease your expenses
A lot people start out with step 2. Most North Americans live a lifestyle so opulent that there’s plenty of meat to cut from the bone. They have closets full of clothes they don’t wear (O.M.G. THIS HOUSE HAS A WALK-IN CLOSET! I AM IN HEAVEN.). They regularly “purge” and “donate” all the useless crap they no longer want, only to replace it with new crap. We continue to buy brand new cars because apparently slightly better reliability is worth hundreds of dollars each month. And I still see perfectly healthy people with no dependents buy life insurance as some sort of investment. “Buy buying now, I’ll save in premiums later!” But… never mind.
There’s a lot of confusion with step 1, and thus many people don’t get anywhere past the basics when it comes to increasing their income. Side hustles are great, since the majority of people go home after work and plunk their ass on the couch. Everyone needs relaxing time, but just about everybody can carve a couple of hours a day to put towards increasing income.
As we all know, there’s a limit to cutting your expenses. You still have to eat, clothe yourself, and get to work. So we have a choice. Should we try and do those things in the cheapest way possible, or should we work on increasing our income so spending $10 on a meal out hardly matters?
For me, the choice is simple. Figuring out a new way to save 14 cents per serving on pizza doesn’t excite me. Getting paid dividends by the pizza company in exchange for giving them money? THAT’S WHAT I’M TALKING ABOUT, BITCHES.
Say I bought 100 shares each of Boston Pizza (TSX:BPF.UN) and Pizza Pizza (TSX:PZA). For a capital outlay of approximately $3,500, I’d get myself monthly income of approximately $17 for a very long time. Sure, there’s a chance each business suffers, but stocks tend to go up over time.
Say I borrowed an additional $3500 to buy 100 more shares of each. I would have doubled my monthly income to $34 while spending $8.75 per month in interest, assuming a 3% loan. If I used both dividends to pay off the loan, I’d be paying off approximately $280 per year.
Okay, but what if I was more aggressive? Say I did my research and came up with a portfolio of 20 names with an average yield of 5%. I have $50k of my own money, and a friendly banker is willing to lend me $50k more. Because I want to maximize the growth of this portfolio, let’s assume I reinvest those dividends, Using $300 per month from my cash flow to make loan payments.
Assuming no growth in the portfolio, here’s what the investment would look like in 5 years.
Value of loan: $32,000
Value of portfolio: $127,628
Total interest paid (remember, this can be wrote off): $6,642
Assuming you’re in the 25% tax bracket, it’ll cost you just under $5,000 in interest (over 5 years, so about $1000 per year) to grow a portfolio by $13,000 more than what you would have just by taking your capital and investing it. And that’s assuming it just grows by the value of the dividends. Over time it’ll most likely do better, especially if you choose undervalued stocks.
This is exactly what I’m talking about. If you borrowed to invest and got just a 5% return, you’re miles further ahead than the person who just invests their savings. Portfolios do go down sometimes, but chances are it’ll continue to go up.
Which brings me to my main point. The easiest way to supercharge your passive income is to borrow to get more of it.
Saving your ass off to accumulate capital is great. Everyone who saves their ass off to accumulate $25k in capital a year gets a Financial Uproar® brand thumbs up. But what’s easier? Scrimping and saving for years to get capital or borrowing it from a bank?
Smart leverage has been around for generations. Embrace it. If you’re not comfortable with stocks, buy a duplex and rent out the other half. Buy a franchise and get your friend to run it, splitting the profits. As long as there’s a reasonable enough expectation for net returns twice as much as the interest you’re paying, do it.
Don’t go nuts and borrow every penny you can get your hands on. Pay attention not only to the amount of leverage you have (I wouldn’t go over 50%, myself) but also your ability to repay if things go poorly. If your investment only makes 3% and not 6%, it’s not so bad if you can still make the payments. That gives you time to either find a buyer, or see if it was a reasonable expectation of recovery.
There’s an element of risk. If you’re not comfortable with taking a few risks, then don’t bother borrowing to buy anything. But at the same time, this is probably one of the easier ways to make more passive income. Over time, chances are you’ll do well at it.
If there’s interest, I’ll elaborate in the future on this, even coming up with a model portfolio. If you’re interested, send me a note or leave a comment.