How Luxury Homeowners Use Intelligent Debt to Get Richer
There have been many books and thousands of newspaper articles written on good debt and bad debt, which has led to confusion on what exactly debt is. Thomas Anderson, Investment Banker, Private Wealth Manager & bestselling author of “The Value of Debt,” summarizes debt nicely by saying: “Swap the good versus bad distinction for the notion of Intelligent Debt.”
High-Net-Worth households have been using intelligent debt for decades to increase their overall net worth and to minimize taxes. Take Warren Buffet for example – how did he become one of the richest people in the world?
The answer is not so simple. Let’s rephrase the question: Would Warren Buffet have become one of the richest in the world had he not boosted his returns immensely by using intelligent debt?
In the research paper “Buffet’s Alpha” by Andrea Frazzini, David Kabiller and Lasse Pedersen, the authors state: “Warren Buffett has boosted his returns by using leverage, andhe has stuck to a good strategy for a very long time, surviving rough periods where others might have been forced into a fire sale or a career shift. We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion.”
But it’s not just Warren Buffett who embraces leverage investing. Every single major corporation in the world uses debt to grow its business. And leverage investing certainly isn’t a foreign concept to luxury homeowners, many of whom view the equity within their house as capital, to be used to create more capital and ultimately to increase their overall net worth.
Two of the most common ways luxury homeowners use intelligent debt to create more capital are by: a) purchasing investments and b) purchasing rental property. The case study we present in this article illustrates the value of purchasing investments such as bonds or stocks; we will cover the immense value of purchasing a rental property in Part 2 of this article.
Here’s a case study of how a mortgage professional used intelligent debt to close a $3.5M deal from a referral she received from a Financial Advisor.
The client in our case study owns a gorgeous home in Toronto valued at $8.5M. He also owns a cottage in Muskoka worth $3.5M. His total real estate value equals $12M. This client has an investment portfolio of $1.5M earning an average annual rate of return of 6% and has zero mortgage debt on any of his real estate holdings. The advisor ran two scenarios past his client:
Option#1: No Debt
In this scenario, the client’s investment portfolio earns an annual rate of return of 6% on average, which equates to $90,000 per year in taxable income on his $1.5M investment portfolio. After paying $31,500 in taxes, the client is left with $58,500 per year in after-tax income—we used a 35% average tax rate in this example.
Option #2: Leverage invest $3.5M
As you can see, there is no change to the value of his real estate; it’s still worth a combined total of $12M. But his investment portfolio has increased from $1.5M to $5M because of the $3.5M loan.
The client’s overall net worth has not increased—$17M in total assets, minus $3.5M in debt equals $13.5M, which is the same net worth as in Option #1.
What changes substantially is his after-tax income.
The interest rate on his line of credit is 3%. The client’s $5M investment portfolio is still earning a 6% rate of return, which will now generate $300,000 per year vs. $75,000 if he had not leveraged, or, as we like to call it “putting dormant home equity to work.” But since the client borrowed money to invest, the interest on his loan is now an expense that is fully tax-deductible. The client is being charged $105,000 interest per year on a $3.5M line of credit at 3.00% interest. This reduces his taxable income from $300,000 to $195,000. The total tax payable is $68,450, leaving the client with an after-tax income of $126,550—this is the bottom line he nets after paying the $105,000 interest expense and after paying his taxes.
This is the exact same person with the exact same initial net worth, but a different decision has been made with respect to debt. By borrowing to invest, the client is now able to generate 116% more than in Option #1 because he is able to deduct his mortgage expense.
Take a look at the compounding effect of reinvesting income, year-over-year, over a period of 10 years.
In Option #1, the client is generating an after-tax income of $58,500. If that is reinvested earning an average 6% per year, the investment portfolio will have grown to just over $800,000 after 10 years.
Now take a look at Option #2, where the client is generating an after-tax income of $126,550.
If this amount is reinvested earning an average of 6% per year, the investment portfolio will have grown to more than $1.7M after the same 10 years. Over a 10-year period, that’s a difference of over $900,000—all because of interest deductibility and compound growth.
Tax deductibility and compounding interest on an investment portfolio is why Intelligent Debt can be a highly efficient strategy of putting dormant home equity to work.
Is borrowing to invest without risk? Of course not. What happens in a rising interest rate environment? Or if the investments earn less than the cost of debt? There is risk to any leveraging strategy and that’s why it’s important for your clients to work with their Financial Advisor and thoroughly understand risk vs. reward before making any strategic planning decisions.
