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.
Random Useless Fact:
Some grocery stores have an aisle dedicated to strong, independent women. 😄