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Leveraged Investing and Prime Interest Rates

In my last Smith Manoeuvre update, a reader commented as to why would I invest in any stocks with yields lower than my interest rate.  To answer the question, to me, it’s not only about the yield, but also the strength of the underlying dividend.  You see, if the company is paying out an above average dividend yield, and a payout ratio (dividend per share/earnings) being high, there is a higher probability that the company will reduce (or even cut) their dividend.

In addition, regular reader, DAvid pointed out that it’s not about the interest rate that you pay on leveraged stocks, it’s the “after tax” interest rate that you pay accounting for the tax deduction.

As the “after tax” interest rate varies depending on your marginal income tax rate and your investment loan rate, I drafted a table indicating what kind of dividend yield your portfolio would require to break even in various circumstances.

Dividend Yield Required to Break Even with Leveraged Dividend Investing

Marginal Tax Rate
HELOC Rate 25% 30% 35% 40% 45%
3.0% 2.25% 2.10% 1.95% 1.80% 1.65%
3.5% 2.63% 2.45% 2.28% 2.10% 1.93%
4.0% 3.00% 2.80% 2.60% 2.40% 2.20%
4.5% 3.38% 3.15% 2.93% 2.70% 2.48%
5.0% 3.75% 3.50% 3.25% 3.00% 2.75%
5.5% 4.13% 3.85% 3.58% 3.30% 3.03%
6.0% 4.50% 4.20% 3.90% 3.60% 3.30%
6.5% 4.88% 4.55% 4.23% 3.90% 3.58%
7.0% 5.25% 4.90% 4.55% 4.20% 3.85%
7.5% 5.63% 5.25% 4.88% 4.50% 4.13%
8.0% 6.00% 5.60% 5.20% 4.80% 4.40%
8.5% 6.38% 5.95% 5.53% 5.10% 4.68%
9.0% 6.75% 6.30% 5.85% 5.40% 4.95%
9.5% 7.13% 6.65% 6.18% 5.70% 5.23%
10.0% 7.50% 7.00% 6.50% 6.00% 5.50%
10.5% 7.88% 7.35% 6.83% 6.30% 5.78%
11.0% 8.25% 7.70% 7.15% 6.60% 6.05%
11.5% 8.63% 8.05% 7.48% 6.90% 6.33%
12.0% 9.00% 8.40% 7.80% 7.20% 6.60%

As you probably concluded already, the higher your marginal tax rate (ie. the greater your regular income), the larger the advantage of leveraged investing. I’m personally in the 40’ish marginal tax bracket with a portfolio dividend yield of around 3.6%.  This means that as long as my investment loan rate stays below 6%, I will remain cash flow positive.  However, it’s a moving target as I expect my dividends to grow over time.

To look at the table another way, with today’s prime rate being 4%, at 40% MTR I would require a dividend yield of just 2.4% to break even.

If you currently have a leveraged income portfolio, are you cash flow positive?

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 15 comments… add one }
  • paul s November 12, 2008, 9:22 am

    It’s an incredible risk to take for small returns. Reality is, the Dow Jones Industrial average adjusted for inflation had an annual retun of 1.56% over the last 40 years. Fees paid make that return negative. If you are NOT getting dividends, then you are losing.

    I say, don’t borrow the money, put your cash every month into GICs (or some guranteed investment). No risk AND relatively equal returns to the market.

    Sadly, the only person making money in that situation is me. Not a Broker, or Trader, or Mutual Fund “Manager”, or the Banker…etc

  • Al November 12, 2008, 9:53 am

    Looking at the broader picture, I’d be closing out a leveraged position if I had one. Tight credit markets should lead to higher cost of borrowing, and the global economic slowdown should have a negative impact on dividend payouts. I used the word ‘should’ in both cases because I don’t have a crystal ball, but basic economics support my conclusions.

  • moneygardener November 12, 2008, 10:13 am

    The chart title should read “Dividend Yield Required To Break Even on Returns From Dividends Alone During Leveraged Investing”. The assumption is always made the not capital gains will be realized. The longer you maintain a strategy such as this in place, the more likely you are to be in a position to realize some capital gains. Being conservative it is wise to ignore this affect, but in reality it should be considered as a piece of the puzzle for someone long term.

  • cannon_fodder November 12, 2008, 10:14 am

    I think another point is that, over time, the gap between the Yield on Original Investment and your interest costs should grow. The interest rates are typically range bound (there are some temporary periods where they are atypically low or high) while the dividend yield should continue to go up. I bought National Bank several years ago and sold it earlier this year (before the meltdown). When I purchased it the yield was around 4%, but after several years the yield rose to over 11% based on my original investment.

    Currently, my non-reg portfolio is yielding 4.80% on my original investment while the interest is at a rate of 3.85%. In after tax terms (FT – did you also calculate the after tax cost of the dividends not just the interest cost?) I’m cash flow positive by 1.6% x the value of my portfolio. Interest rates will be going down again and stay low for several months before beginning their rise. That will happen when the economy starts picking up significantly which should translate into higher company profits which will result in increases in the dividend yields.

    Unless the economy starts boiling over, I don’t anticipate being cash flow negative with this portfolio.

    A final note – the tax rates vary by province. The dividend tax rates are least favourable in Quebec, with Alberta, BC and the Yukon the best provinces in which to collect dividends.

  • FT FrugalTrader November 12, 2008, 10:24 am

    Good eyes CF, I didn’t account for the dividend tax where I probably should have. The bright side is that dividend taxes are very low and even nil for the average person in some provinces (like BC).

    For those of you interested, here are the tax rates across Canada:
    http://taxtips.ca/marginaltaxrates.htm

  • DBennett November 12, 2008, 10:39 am

    Hey,

    I’m currently a student and have a student line of credit with interest only payments (for the next 2.5 years). I was thinking about using $5k as a leveraged investment in this market. The great advantage I have right now is, if the dividend yields exceed my interest rate (prime plus 1) or close to it, I essentially pay nothing for “renting money”. Currently I own BMO, Husky Energy, and Yellow Pages. All pay over a 6% dividend. If I invested similar with a leveraged portfolio, it could be a good buy. BTW, I am a Commerce student majoring in Finance if that helps.

    What does everyone think?

  • Finance_Addict November 12, 2008, 10:53 am

    I don’t just focus entirely on cash flow because as moneygardner pointed out you don’t just need yield but also capital gains to keep score. I disagree with paul s comments. It’s the fact that you leverage that significantly amplifies any gains (and losses.) However you have to at least get in the game if you want to win. I agree with Al that there will come a day when using a HELOC will become more expensive. If that is the case one can scale back or wait and pick your spots. Building a portfolio where your cash flow positive is clearly a good approach but your real gains will not come from your yield but from capital gains.

  • Dividend Growth Investor November 12, 2008, 11:00 am

    I guess my only concern is aren’t your monthly payments of the heloc made up of interest and principal? If you only pay out the interest, then I see how you could be cash flow positive.. If you also have to pay principal as well, then you might have to sell stock to cover the monthly payment even if your dividend yield on cost increases over time..

  • DAvid November 12, 2008, 11:24 am

    Dividend Growth Investor,
    In Canada at least, HELOC are interest only.

    DAvid

  • GKH November 12, 2008, 12:11 pm

    When I was starting out some thirty years ago I had no money to invest in stocks so I borrowed it against my credit cards. I reinvested all dividends, sold off my portfolio to move half way across the world, and started the entire process again. Today I sell covered calls on several key holdings, have invested in several bond funds paying out monthly dividends, and still re invest everything. Note this is all in my IRA.

    The markets will come back. They always do and stocks that pay a dividend and have options to buy or sell is the only way to go.

  • Brad Castro November 12, 2008, 12:48 pm

    I’m a little like GKH. I’ve used 0% promotional credit cards in the past. My Leveraged Investing is through a combination of options and stocks – writing puts to acquire stocks I want (high quality dividend payers) at a discount and then selling covered calls for additonal income once I’ve acquired the stock.

    The trick about covered calls is to only write on a portion of your holdings – that way the unused portion of your portfolio is there if you need to roll out and up on the first batch of covered calls without taking a loss on the calls. The biggest risk with covered calls, after all, is to the upside when the underlying stock makes a big move up. My objective is to generate additional income without having to sell the stock against my will.

    Good luck –

  • Paul S November 12, 2008, 12:48 pm

    Another lower risk way to leverage is by borrowing from a Universal insurance plan and investing the funds. The risk is lower because no matter what happens to the market (account value), you are going to die and pay your debts. :-)

    Happy thoughts…

  • BrianM November 12, 2008, 1:20 pm

    Do you also have to consider differences in compounding periods for the HELOC vs dividend yield?

  • Dividend Growth Investor November 13, 2008, 3:12 pm

    DAvid,

    That’s makes sense, thanks for your input!

    Dividend Growth Investor

  • John November 29, 2008, 1:50 pm

    If the asset you buy falls in value you are done. Think of the situation of investors who bought elements of XDV in the last 6 months that are down 30 to 40% this year. It may be years until they make it up the capital losses

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