About financial leveraging

Dealing sensibly with mortgage payments - a flexible consolidation

Dealing sensibly with mortgage payments - Make it tax-deductible!

Why and how to buy mortgage insurance?

If you have a mortgage or other debt outstanding, it is standard practice to include the whole outstanding debt when calculating somebody’s need for insurance. Life insurance (traditionally, term life coverage with decreasing face/benefit value) for this purpose is and old topic. Recently, offering and buying critical illness insurance to ensure that mortgage payment obligations will be met whatever happens has become customary. Considering that a high percentage of mortgage foreclosures is due to death, injury, or illness, it is very reasonable. With mortgage life insurance, it has been clearly demonstrated that the customer is much better off (on several counts) if they buy the insurance individually from insurance companies, rather than from the bank that offers the loan. The same can be told about critical illness insurance that is more and more often offered today by the same lending institutions.

Policies from the lenders are there first and foremost to protect them (the mortgagees), not the borrowers (the mortgagors). Another false logic some people use to conclude that they should buy the protection from the lenders says that since the outstanding mortgage debt is gradually decreasing, buying any kind of insurance with level benefit amount is superfluous, thus just a waste of money. It is very doubtful that the sole sensible reason to buy insurance would be the mortgage payment obligation for anybody, on the one hand; there are decreasing benefit amount policies available from insurance companies as well, on the other hand. Interestingly though, one can easily find that these policies with decreasing benefit amounts are not necessarily cheaper than policies where the benefit amount stays even. Being penny wise is really being pound foolish sometimes, and the only sensible approach is to shop around and see what is the best option in any given situation or at any given time.

About financial leveraging

Leverage is a divisive and controversial financial concept, with good reasons. Leveraging means using borrowed money to invest. It can multiply the outcome of investing, in both directions: gains or losses. Therefore, it is not for everyone. It does make sense, but only if there is a willingness and (financial and psychological) ability to absorb potentially big losses.  Another important requirement is to have sufficient cash-flow to be able to service the loan. (Please see the full text of the leveraging disclaimer below that everybody who opens a new account has to sign.) Despite of these requirements, millions of people, not just the wealthy and the gamblers, use leverages successfully. It is so, because buying a house on mortgage is essentially leveraging. True, the initial or basic motivation is usually providing housing and lifestyle, rather than increasing investment returns. However, the need to service the loan is just the same, and the multiplied gain or loss do come into play at he time of sale, either voluntarily or due to circumstances.

Here is a checklist of general questions to consider before making any leveraging decision:

    - Is the borrowed money being invested for the long term?

    - Is there solid cash flow available to service the debt, other than from the investment?

    - Is your cash flow / income stable?

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Frequently Asked Questions

    - If interest rates rise and your monthly payments increase, will your cash flow be sufficient to cover the increase?

    - If your circumstances changed (e.g. loss of job) could you carry the loan through and emergency fund reserve?

    - If you have to liquidate your investments to pay off the loan at a time when your investments dropped in value, do you understand that you may have to sell your investments at a loss, and you may incur redemption fees?

    -Do you have available funds in reserve to pay any remaining loan balance if the value of your investments were insufficient to cover the loan outstanding?

    - A conservative amount to borrow should not exceed 30% of your liquid net worth. If there is sufficient cash flow to service the debt, 50% of your liquid net worth may be acceptable. Do you agree that you are borrowing a reasonable amount based on your financial circumstances?

    - Do you have a plan to pay down the principal amount of the debt over time other than to sell the investment?

Dealing sensibly with mortgage payments - a flexible consolidation

Many homeowners strive to pay off mortgage as soon as possible, because they are basically uncomfortable with the concept and risks of leveraging, and/or simply because they are aware of the huge interest payment accumulating during the years. Many people have large credit card loans, car loans, and other types of debts that they pay even higher interest on than on the mortgage. At the same time, most people keep not insignificant amounts on their chequing accounts, where the money earns hardly any interest. In addition, they may keep a few thousands in savings accounts, that is away from investments, for unforeseen emergencies. Some have an open credit line from similar considerations, some don't. Combining all these things into one flexible account makes a lot of sense. Seemingly perhaps small effects, when they get combined and repeated months over months, can create huge differences in outcomes (in terms of length of payback periods, amount of interest paid, or simply the growth of assets) within a few years. Emphasizing this, I alter from my intention to not promote any particular financial product here, ... simply because there is only one single such product on the market as of today. It is available for many people, and I am ready to explore it with you, and help you to take advantage of it

Dealing sensibly with mortgage payments - Make it tax-deductible!

Relating to loans, mortgages, and leveraging, there is a significant fact that most people do not know, or at least do not use extensively enough: interest on certain loans can be deductible. Businesses and the wealthy very often use this rule to their great advantage, but the public in general passes on a great opportunity in this regard. To indicate the magnitude of the issue, here come a few numbers that most of us would probably guess incorrectly off-hand:

The interest paid on a $100,000 mortgage amortized over 25 years, at 7% annual interest rate, totals $110,120. If you are in a 40% tax-bracket, you have to earn $350,201(pre-tax) to pay off this debt (principal plus interest). We are talking about huge amounts and long term here. Without too much difficulty, a proportionate (that is still large) amount of tax-return can be generated and invested, immensely increasing the wealth generation of millions of people. For many, in a few decades, it can easily make the differences of several hundred thousand dollars, or more. The essence of this strategy is the transformation of ‘bad’ (that is not tax-deductible) debt into ‘good’ (that is tax-deductible) debt. It can be used in various ways, according to individual circumstances, attitude, and risk tolerance, ... just like any leveraging. The main point is, however, that even if it is applied without increasing the level of leverage at all, it can be very beneficial to many people.

Leverage risk disclosure, to be signed at new account opening:

Mutual fund units and other securities may be purchased using available cash or a combination of cash and borrowed money. If cash is used to pay for the purchase in full, the percentage gain or loss will equal the percentage increase or decrease in the value of the securities. The purchase of securities using borrowed money magnifies the gain or loss on the cash invested. The effect is called leveraging. For example, if $100,000 of mutual fund units are purchased and paid for with $25,000 from available cash and $75,000 from borrowings, and the value of the fund units declines by 10% to $90,000, your equity interest (the difference between the value of the securities and the amount borrowed) has declined by 40%, i.e. from $25,000 to $15,000.

It is important that an investor proposing to borrow for the purchase of securities be aware that a purchase with borrowed monies involves greater risk than a purchase using cash resources only.

To what extent a purchase using borrowed monies involves undue risk is a determination to be made by each purchaser and will vary depending on the circumstances of the purchaser and the securities purchased.

It is also important that the investor be aware of the terms of a loan secured by securities. The lender may require that the amount outstanding on the loan not rise above an agreed percentage of the market value of the securities. Should this occur, the borrower must pay down the loan or sell the securities so as to return the loan to the agreed percentage. In our example above, the lender may require that the loan not exceed 75% of the market value of the mutual fund units. On a decline of value of the units to $90,000 the borrower must reduce the loan to $67,000 (75% of $90,000). If the borrower does not have cash available, the borrower must sell units at a loss to provide money to reduce the loan.

Money is, of course, also required to pay interest on the loan. Under these circumstances, investors who use borrowed funds to purchase their investment are advised to have adequate financial resources available both to pay interest and also to reduce the loan if the borrowing arrangements require such a payment.

These web pages are for information purposes only. The information contained and presented, while based on and obtained from sources we believe to be reliable, is not guaranteed either as to its accuracy or completeness. The content of these web pages is solely the work of the author, Laszlo Kramar.

The views (including any recommendations) expressed on these pages are those of the author alone, and they have not been approved by anybody. Neither the information nor any opinion expressed herein constitutes an offer, or an invitation to make an offer, to buy or sell any product discussed or referred to in these web sites. These web pages are for educational purposes only and are not intended for use by residents of the United Sates; nor are they intended as an offer or solicitation in any jurisdiction outside of Ontario, Canada. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

(c) Copyright 1997-2006 László Kramár. All Rights Reserved.