May 222017
 

Some people are so debt averse they even refuse to borrow money when interest rates are at rock bottom. They save up for a 30% down payment for a home instead of 20% because they want to save on interest costs. This is despite the fact that Canadian mortgages only cost about 2.5% currently, or sometimes lower like in my case. These people also refuse to invest on margin. I’ve explained in the past how anyone with at least $10,000 can open an account with Interactive Brokers, put in some money, and safely borrow modest amounts of money at just 2% interest rate, with practically no risk of getting a margin call.

Can’t have it both ways

Yet, many people who are debt averse and won’t borrow money under any circumstances also believe in the 4% rule of investing. But this kind of thinking is contradictory. It’s silly to make the argument that paying down their mortgage is a guaranteed rate of return, but investing is uncertain and they can’t be sure they’ll make more than 2.5% return in the markets. While at the same time, also claim that the 4% rule is valid.

The four percent rule is a widely accepted rule of thumb used by many investors and financial experts. There are slightly varying definitions of it, but for the purpose of today’s post we’ll define it as the maximum sustainable rate of withdrawal from a retirement account each year without depleting the account itself. This is because 4% is considered a “safe” rate of withdrawal over the long run for a balanced and diversified portfolio.

So if a person really believes in the 4% rule and uses it as part of his retirement planning, then it would only be rational to consider borrowing money to invest if the cost to borrow is lower. The 4% rule says that this person will make at least 4% return on his investments per year on average. So if he always borrow money at less than 4%, then he is virtually guaranteed to profit in the long run! assuming the 4% rule holds true.

This is why I always buy properties using very low down payments, and use controlled margin borrowing to invest. Since I believe in the 4% rule, it would be illogical if I didn’t try to take advantage of low interest rates. If my margin or mortgage interest rate were to increase to 5% or 6% some day, then of course I would no longer take out new loans to invest. At that point it wouldn’t make sense to use leverage anymore. Sometimes it may seem like being debt free is more safe. But there is risk in being overly debt averse, the risk of not seeing perfectly good opportunities to earn higher investment returns.

Obviously just because a rule has held up in the past doesn’t mean it will continue to hold true in the future. Whether or not you think the 4% rule is valid is up to you. 🙂 But this principal can work with any other withdrawal rate. If you believe you can safely and sustainably withdrawal 3% a year, then you must also accept that your portfolio will return 3% a year minimum on average. You can then use this number as your reference point when deciding when to use leverage and how much.

 

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Random Useless Fact:

Some grocery stores have an aisle dedicated to strong, independent women. 😄

 

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19 Comments on "Leveraging on the 4% Rule"

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DivHut
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4% rule or not… that random useless fact was very, very funny. Thanks for making me laugh!

Buy, Hold Long
Guest

I always try to test the norm, just because the 4% rule is widely accepted doesn’t mean it will work with everyone, I hope you can achieve the 4% rule. Also that last fact is quite funny!

Nomads With a Vision
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Nomads With a Vision

Enjoyed the article and I think it’s an interesting argument, but I think you may be misstating the 4% rule. This is a “rule” based on the Trinity study that suggests a 4% withdrawal from an index portfolio of 50% stocks and 50% bonds has a very high probability of lasting 30 years. Many of the scenarios in the study end with the portfolio at equal or greater value than the start, but it was counted as a success if the portfolio value was 0 at the end of the 30 years, as long as it didn’t go negative. So, it really didn’t have anything to do with expecting a 4% or greater return. Early Retirement Now has done some great work showing that even 4% withdrawal may not be sustainable for the typical early retiree and that it may be closer to 3.3%.

FI3000
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I have to agree with Liquid. Todays interest rates are so low that it seems silly to not borrow to invest. For example, I just bought a small rental unit entirely with leverage at 2.4% interest locked in for 5 years. Over the last 3 years I’ve also bought a basket of dividend paying stocks that all pay a higher dividend than the interest on the loan…plus you get to write off the interest on your taxes!

Martin
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I do not believe in 4% and that’s why I invest in dividend stocks and trade options so my invested principal is still the same and I take off dividends and premiums.

Because of that, I am OK taking out any loan as long as its interest is lower than what I can make in dividends or premiums. Currently, my average dividend yield is 5% annually and my options trading revenue at 8.44% monthly I can take literally any loan and be OK.

I am a true believer in leveraging and I think a young person can afford being aggressive using higher leverage and de-leveraging as you age. Options are a great tool to use leveraging as well as margin trading/investing. Borrow as much as you can, invest it now and over time slowly pay it off. Your investments will make you more than the interest paid on loans.

Other than that I agree with your view.

AlW
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AlW

300K borrowed at 2.7% and invested in private mortgages paying 12-16% never had to foreclose & rarely a late payment.

beth
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beth

My bank has an offer for a locked in interest rate of 2.99% on my LOC. My dividend stocks and ETFs pay at least 4% in dividends and also have growth in their stock price. I am very tempted but is there an age limit for these daring ideas?

I am single, with a very steady job and I am in my early 50s. I want to retire in the next 3 to 5 years. I have never taken a risk like this. My current debt is $12,000 and I have $25,000 worth of contribution space in my TFSA. I could buy some boring ETFs that pay a decent dividend.

I am not sure if I should take this huge leap.

John R
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John R
Beth that sounds like a decent deal on the LOC. On the $12k debt, if that isn’t earning you any income then why not pay off that debt? On what to invest in – well that’s the million dollar question isn’t it, from ETF, ETN, CEF, stocks or mutual funds, MIC’s, private investments or real estate. You never know what what going to happen from will your holdings drop, will they continue to pay out dividends. Folks will tell you ETF’s or this that & the other stock is as good as it gets to mortgage fund investing or buying an income property. If you are going the ‘leverage route’ try as best you can get a rate of return higher than what you are paying in interest. Many on here could suggest an investment, then if you follow what they suggest & the investment goes the wrong way, then what? In your 50’s I would suggest stop contributing to RRSP’s, Max on the TFSA & to consider investing in an passive income generating product. Generally the closer you get to retirement age the investments should be less risky BTW, my wife & I are 70 years old retirees. We… Read more »
Reader
Guest
Reader

How do you calculate you are on track for retirement? Is there an online calculator or math formula/spreadsheet you use? Can you please share these calculator links? Thanks.

Ra D
Guest
Ra D

Have to consider tax on the income from dividends.
After tax yield = Yield*(1-tax rate)

The Risk Runner
Guest
The Risk Runner

I have to say this is one of the most financially savvy blogs I have ever read. Its unbelievable you majored in art and use such professional investing techniques. Well done.

I would warn though, trading on margin is incredibly risky and should be reserved for professional investors. Leverage can be a powerful way to invest in real estate or start a businesses but this late in the business cycle it leads to materially unworthy investments.

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