Leverage of Stocks

Mortgage Deduction Strategies Under The Tax Reform

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Quiz!

Which of the following are true?

  1. You cannot deduct interest on any mortgage above 750k.
  2. You can only deduct interest on a mortgage above 750k if the mortgage was established before 12/15/2017.
  3. You can deduct interest on a mortgage above 750k only if its lowest balance before the tax reform was over 750k, and even if you refinanced it since then.
  4. You can deduct interest on a mortgage above 750k for any mortgage that was taken before the tax reform.
  5. You may get a deduction on mortgage interest, for mortgages above 750k, regardless of when the mortgage was taken.

Mortgage Deduction Strategies Under The Tax Reform

The tax reform that was signed on 12/22/2017 (Tax Cuts and Jobs Act), reduces the mortgage deduction from $1M to $750k and eliminates the home equity debt interest deduction of $100k. This article presents how it can impact you, and strategies for lessening the impact.

  1. Enjoy Grandfathering: While new mortgage debt above $750k does not get a tax deduction, you can continue to enjoy up to $1M deduction on existing mortgages & loan amounts preserved through refinances. Strategy: Refinance with a larger and/or interest-only mortgage, and keep refinancing to keep the mortgage from dipping below $1M (or below your existing balance between $750k and $1M). Examples for the grandfathering:
    1. You took a 1M mortgage in the past and by 2017 the balance was down to 600k. Deductions on future refinances will be limited to interest on 600k, even if you increase the borrowed amount. If the balance goes down to 500k in 2020, deductions through future refinances are limited to interest on 500k.
    2. You took a 1M mortgage in the past and by 2017 the balance was down to 900k. If you refinance to 1.2M, you keep getting a deduction on interest on 900k, as long as the balance is over 900k.
    3. You took a 2M mortgage in the past and by 2017 the balance was down to 1.5M. The balance keeps declining to 1.4M by 2018, and then you refinance with a 2.2M mortgage. At all times, you get to enjoy the full deduction of interest on 1M.
  2. Get Investment Interest Expense Deduction: Whether you have a new mortgage above $750k, an old mortgage above $1M, or a HELOC (Home Equity Line of Credit), you may be able to get a partial or full deduction vs. investments income (interest, dividends or capital gains). This deduction is called “Investment Interest Expense”, and is given because you technically borrow to invest, whether you intended to do so or not. This is evident if you compare your current reality relative to selling from your investments to pay off your home loans. By keeping both the loan and the investments, you are borrowing to invest. A few notes:
    1. The deduction is available regardless of the source of investment income. For example, if you have a $100k HELOC costing you $5k per year in interest, and a $500k investment generating 1% realized annual income = $5k, you can use that.
    2. If you don’t have enough investment income in any given year, you can defer the disallowed interest amount to the next year, and continue to do so indefinitely. If your investment has high average growth and generates income and/or capital gains, you may have a chance of enjoying the disallowed deduction later on.
    3. Taking the deduction vs. investment income that is taxed at your marginal tax rate (i.e. short-term gains & non-qualified dividends) gives you the full benefit, like the mortgage & HELOC deductions.
    4. If you don’t have enough of the ideal investment income mentioned above, you can elect to take deductions vs. long-term gains & qualified dividends. You have to decide whether taking the lesser deduction today is better than the full deduction later on, requiring some analysis. This decision may not apply to state taxes where there is the same tax rate for both types of investment income.

Important notes:

  1. You should only borrow to invest if the investments are likely to provide materially higher growth than the interest on your loans, or you are seeking liquidity as part of your risk plan and willing to accept the interest costs.
  2. Do a very careful risk analysis that prepares you for a great deal of bad luck. Don’t forget what happened to those who skipped this step in 2008.
  3. You need perfect discipline through the market cycles. The best risk analysis won’t protect you if you panic-sell at the bottom of a decline.
  4. Always do a full comparison of the current picture vs. the new one you are considering, to see if the change is beneficial. The most common failure results from considering one or two factors in isolation, without the remaining moving parts. For a refinance, start with risk planning, then include: estimated refinance costs, change in rate, impact of cash flow change (e.g. between interest-only and fully amortized), and any change in tax benefits. Sometimes the decision will be simple, and sometimes it will require a full simulation in a spreadsheet.

Also, remember that I am not a CPA, and I recommend consulting with a CPA on all tax matters.

Quiz Answer:

Which of the following are true?

  1. You cannot deduct interest on any mortgage above 750k.
  2. You can only deduct interest on a mortgage above 750k if the mortgage was established before 12/15/2017.
  3. You can deduct interest on a mortgage above 750k only if its lowest balance before the tax reform was over 750k, and even if you refinanced it since then. [Correct Answer]
  4. You can deduct interest on a mortgage above 750k for any mortgage that was taken before the tax reform.
  5. You may get a deduction on mortgage interest, for mortgages above 750k, regardless of when the mortgage was taken. [Correct Answer]

Explanations:

  1. If the mortgage was taken before the tax reform and was kept or refinanced to a similar/higher balance, you can get a deduction up to 1M.
  2. If you refinance a >750k mortgage and keep the balance higher than 750k, your deduction is grandfathered.
  3. Old borrowed amounts are grandfathered. Specifically, as long as you sustained your mortgage balance above 750k, you get to keep the deduction on interest up to 1M. This holds even through refinances.
  4. Not true if the mortgage balance went below 750k at any point.
  5. A bit tricky, and is true because you can get a partial or full investment interest expenses deduction on disallowed mortgage interest amount, depending on your investment income. The article explains this further.
Disclosures Including Backtested Performance Data

Growing College Savings Fast Despite the Short Horizon

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Quiz!

What is the most powerful way to maximize the value of college savings?

  1. Include increasing amounts of bonds and cash, reaching 100% as your child reaches 18, to minimize the chance of losses due to stock declines.
  2. Maximize 529 plan contributions – while returns are unknown, tax savings are a guarantee.
  3. Allocate 100% of the savings to stocks, and be prepared to take temporary student loans in case of a stock decline during college years.
  4. Create a balanced allocation of stocks & bonds, while maximizing the tax benefits of college saving plans, including both 529 & Coverdell ESA.

Look for the answer below.

Growing College Savings Fast Despite the Short Horizon

Problem: Saving for college involves a tough combination:

  1. College costs are high and grow fast (over 5% historically), requiring the help of a fast growing investment such as stocks.
  2. The time horizon is limited and fixed at 18 years, making the volatility of a stock allocation problematic in the later years. Imagine a stock allocation in 2008 right as your child reaches college age.

Solution:

  1. Invest 100% in stocks, if you (or your advisor) can stay disciplined through tough market downturns, and as long as you have strong stock-, sector- and country-diversification. Otherwise, include as many bonds & cash as needed for you to be able to stick to your plan through declines such as 2008.
  2. Once you reach college years, if there is no major decline, you can sell from your college savings, and enjoy the high likely average growth.
  3. If there is a major decline during college, you can take a student loan. This stretches the expense and lowers your yearly cash outlay during the decline. Once the investment recovers from the decline plus extra to make up for the loan interest & the limited sales during the decline, you can pay off the loan reducing or eliminating the penalty for the decline.

Additional thoughts:

  1. Currently, college saving accounts (529 & Coverdell Education Savings Account) cannot be used for paying off student loans. To enjoy this strategy, you should limit the amount of savings in these accounts. Notes:
    1. You can still use these accounts to pay for student loans that are used for current-year expenses.
    2. A bill (H.R.529 – 529 and ABLE Account Improvement Act of 2017) was introduced in January 2017 to allow use of the account to pay for student loans, but it is just in the proposal phase.
  2. There are additional reasons to limit the use of college savings accounts, despite the tax benefits. Saving too much can happen for numerous reasons:
    1. High investment growth.
    2. Lower college costs, e.g. through proliferation of online (or partly online) programs.
    3. Getting a large scholarship.
    4. Going for a cheaper university than the parents planned for (e.g. an in-state college).
    5. Skipping college altogether, and starting a business.
  3. You can benefit from maximizing a Coverdell ESA (Coverdell Education Savings Account) before using 529, for several reasons:
    1. Nearly unlimited investment choices, just like IRAs, allowing for more optimal growth, when given to the right hands.
    2. Unlike 529, the money can be used for grade-school expenses. This can help in case of saving too much.
  4. You can benefit from avoiding 529 altogether. The Coverdell ESA account is limited to $2,000 contribution per year, which significantly reduces the risk of overshooting the saving amount, especially if (but not limited to) you end up taking temporary student loans.
  5. This plan does not get in the way of you gifting the college expenses: you can gift the loan payments. If done right, you are likely to end up with a lower cost regardless of your luck with the investments, as long as you hold onto the loans until the investments go through enough of the up years of the cycle.
  6. Another consideration: the more college years you expect, the lower the overall negative impact of declines, even without the help of temporary student loans. For example, if you have 2 children, 2 years apart, and each studies for 4 years, the expense is spread over 6 years.

Quiz Answer:

What is the most powerful way to maximize the value of your college savings?

  1. Include increasing amounts of bonds and cash, reaching 100% as your child reaches 18, to minimize the chance of losses due to stock declines.
  2. Maximize 529 plan contributions – while returns are unknown, tax savings are a guarantee.
  3. Allocate 100% of the savings to stocks, and be prepared to take temporary student loans in case of a stock decline during college years. [The Correct Answer]
  4. Create a balanced allocation of stocks & bonds, while maximizing the tax benefits of college saving plans, including both 529 & Coverdell ESA.

Explanation:

  1. While bonds and cash reduce the downside, they also limit the upside. There is a way to limit the downside without this sacrifice (see the correct answer, #3).
  2. There are two problems with this solution: (1) You can over-save, resulting in a 10% penalty on the excess + income tax on the gains on the excess, if you can’t find a family member that under-saved; (2) 529 plans have limited investment options with a drag on returns that may be greater than the entire tax benefit.
  3. This optimizes the growth combining the following: (1) fast growing stocks; (2) moderating or completely reverting downturns by spreading the withdrawals over many years, in case of a decline in college years.
  4. See #1 & #2 above.
Disclosures Including Backtested Performance Data

When Increased Leverage can Improve Your Short-Term Security

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Quiz!

Which of the following statements are true?

  1. Borrowing to invest can make anyone wealthy.
  2. Borrowing to invest in a volatile fast growing investment, leads to higher long-term security at the price of lower short-term security.
  3. Borrowing to invest is never smart for young people.
  4. Borrowing to invest is never smart for retirees.

When Increased Leverage can Improve Your Short-Term Security

Borrowing to invest can let you enjoy excess returns equaling the investment growth minus the loan interest. While you commit to a fixed cost, to enjoy a volatile benefit, there is a case that can increase your overall short-term security, in addition to the typical higher long-term security. An example can demonstrate this point. Please read carefully the assumptions & notes below – most people are better off not borrowing to invest.

  1. Say you have $100k in investments (in Extended-Term Component), a $1M house with no mortgage, and you spend $100k per year. If you lost your job for more than about a year, you can be wiped with no cash to support yourself.
  2. Now, assume that you borrow $800k at 5% interest-only, and add to your investments. Even under tough investment scenarios, you can survive the 2 years out of a job.

The following table summarizes the impact of the borrowing-to-invest:

Impact of different leverage choices, with $100k in investments (in Extended-Term Component), $1M house, and a 2-year job loss, leading to $200k withdrawals
Case No mortgage $800k mortgage @ 5%
Good: Starting at 2003 Out of cash after 1.5 years +$1.74M after 2 years, owe $800k
Bad: Starting at 2008 Out of cash after 0.8 years +$410k after 2 years, owe $800k

The leverage helped you avoid bankruptcy, by turning your illiquid house into a liquid source of cash. Surprisingly, whether your unemployment occurs during a stock surge, or the worst crash of your lifetime, it helps you survive an extended period of unemployment.

Important assumptions & notes:

  1. This article reviews only one aspect of leverage. The topic is complex and requires a thorough risk analysis.
  2. While the short-term security goes up in this case, and the long-term security would typically be higher, there could be a combination of an extreme decline combined with many years of withdrawals, that can negate the long-term benefits, resulting in an overall loss.
  3. The key to the increased short-term security is the improved spending/assets ratio. In the example above, there is a dramatic improvement from 100% ($100k/$100k) to 16% ($140k/$900k). If the interest on the loan is higher than your current spending rate, the loan will hurt your short-term security. This is typical of retirees. For example, if you have $4M and spend $120k/year, your spending rate is a comfortable 3%. Adding the loan, will increase your spending rate to 3.33% ($160k/$4.8M). While your long-term security can still benefit, it is not recommended for retirees, especially if the new withdrawal rate is high enough to lead to problems under severe declines.
  4. The loan cannot be called. This is typical of mortgages in the US, assuming you make all payments on time. This is not true for margin loans that may be called at the worst time – at the depth of a market decline.
  5. You invest the entire loan amount.
  6. Your spending habits stay the same, and you don’t get tempted to increase your spending with the extra $800k in the bank.
  7. You don’t sell in a panic after a decline like 2008, and don’t get a heart-attack. Either can turn the temporary decline into a permanent loss.
  8. As soon as you find another job, you go back to saving regularly. You never withhold investing at low points (after big declines).
  9. You may enjoy some of the short-term benefits above using a HELOC – a home equity line of credit, that is left not borrowed until the need comes up. There are some pitfalls to HELOCs to watch out for: (1) in rare cases it may be frozen to new borrowing, and (2) the interest rate is usually higher than mortgage rates. Also, without the actual borrowing to invest, you can’t get the long-term benefits.
  10. In the example above, you may be able to sell the house, but there are a number of issues with this plan: (1) When selling the house, you turn a temporary problem (job loss) into a longer-term issue – selling a house, moving, maybe later buying another house, and paying realtor fees; (2) You would not want to sell too soon, while hoping to find a job, but if you wait too long, you may need to sell in a rush, leading you to get underpaid for the house.

Quiz Answer:

Which of the following statements are true?

  1. Borrowing to invest can make anyone wealthy.
  2. Borrowing to invest in a volatile fast growing investment, leads to higher long-term security at the price of lower short-term security.
  3. Borrowing to invest is never smart for young people.
  4. Borrowing to invest is never smart for retirees.

None of the statements are true! Explanations:

  1. If you can qualify for large loans, you invest the full proceeds in a fast growing investment, you never panic and sell at a decline, you do a careful risk plan and a host of other conditions, you have a chance to become wealthy. If you mess up any of the conditions, you can go bankrupt, even if you started as a billionaire.
  2. See this month’s article – under certain conditions, you may enjoy higher short-term security along with a typical higher long-term security.
  3. Borrowing to invest may be smart for young people under the right conditions, and after a careful risk analysis.
  4. Borrowing to invest is typically not smart for retirees, but there may be unusual circumstances, where a retiree can maintain a very low withdrawal rate despite the borrowing, and also prefers the higher potential growth despite the higher volatility.
Disclosures Including Backtested Performance Data

Should you Leverage your Stock Investments?

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[Updated February, 2011]

How does stock leverage work? It is very simple: you open a margin brokerage account. This type of account lets you borrow from your broker to fund part of your investment. Your investment serves as the collateral, just like your home serves as the collateral for a mortgage loan.

Since stock values tend to be very volatile there are strict rules to limit the losses to your broker (set by the Federal Reserve, the National Association of Securities Dealers (NASD), the New York Stock Exchange (NYSE) and individual brokers). Specifically, you are required to provide at least 50% of the security value when you purchase it, and keep having your investment be at least 25% of it on an ongoing basis. Individual brokers may have more stringent requirements and may change them without prior notice.

If your investment value declines and you don’t own enough of your investment your broker may sell some or all of the investment to bring your ownership to the required percentage. The following example demonstrates the financial impact.

Example . You have $500,000 and would like to leverage your investment using your broker’s money. You can invest up to $1,000,000, making your ownership 50% of the investment, and the broker finances the other 50%. From now on, you own the investment minus the loan value of $500,000. This amount is required to always be at least 25% of the investment value. The indented text below presents math calculations of the effect of these rules. You can skip it, if you don’t care for the details.

If we denote your investment value by X, we can express the requirement as follows:

X – $500,000 > 0.25 X

Let’s solve the inequality:

0.75 X > $500,000

X > $666,667

If your investment declines by more than 33% (($1,000,000 – $666,667) / $1,000,000), you should expect the broker to sell some of your investment to bring the ratio to the level required.

As shown above, the requirement of owning at least 25% of the investment is deceiving. In practice, a decline of 33% or more will result in the broker selling some of your investment to cover the excess loan.

Moreover, if your investment goes down to $500,000, you own nothing ($500,000 investment value minus $500,000 loan), your full investment will be sold and the proceeds will be taken by your broker. You will lose your entire investment.

Should you Leverage your Stock Investments? Like any other investment decision, answering this question requires an analysis of the risks and rewards.

Risks . As presented in the previous article “How does Leverage Work?” (Hanoch, June 2007), borrowing to invest can significantly increase the risks of your investments.

  1. Severe decline : In the example above, if your investment declines by 50% or more, you lose your entire investment. Since the most conservative stock investments (globally diversified, no stock selection, no market timing) tend to decline by 50%+ in the worst recessions, borrowing 50% of the investment is too aggressive, making bankruptcy a real possibility. You can decrease this risk by borrowing a much lower percentage. There is no way to predict the worst future decline, but since that decline could make you go bankrupt, I would choose a very conservative measure in the range of 5%-20% (withstanding an 80%-95% decline).
  2. Change in broker rules : Your broker may change its rules without any prior notice and require much higher ownership of your investments up to 100% (all lending to you is cancelled). Unfortunately for you, a change in rules is most likely to happen during a severe recession, when your broker is most concerned about a default on your loan.
  3. Loss of income : Without leveraging you can use your stock portfolio to supply you with a certain level of income, even during recessions. The amount depends on the specific portfolio, especially how diversified it is. For Long-Term Component, a reasonable withdrawal rate is 4%, growing with inflation. Once you leverage your investment, you may not have the money for withdrawals during recessions. If you depend on any portion of your portfolio for living expenses, you should not consider leveraging.

Rewards . Let’s see what your potential reward is if you borrow 20% of your investment – the most I could contemplate borrowing even while being overly aggressive.

  • 2% potential gains : You may be able to achieve investment gains of about 10% above margin rates (say 15% returns for a globally diversified stock investment, with 5% margin interest). This can increase your returns by 10% additional gain on 20% of your investment, or 2% (10% x 20%) additional return on your total investment. This is probably not worth the risk, however remote, of bankruptcy, due to a margin call at the bottom of a major decline.

Summary

Since we cannot know how deep a stock portfolio may decline temporarily and how brokers might decide to change their lending rules during recessions, any margin borrowing imposes some risk of bankruptcy. In addition, you eliminate the ability to use the portfolio for income at all times. With the potential benefit being limited to about 2% increased gains, I conclude that it is not worth borrowing using your stock investments as collateral, even if you are looking for very aggressive ways for making money.

Disclosures Including Backtested Performance Data

How does Leverage Work?

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Leverage is a powerful tool that can be used to magnify the returns on your investments. Understanding the financial results of leverage requires some mathematical calculations. If the calculations presented below are not interesting to you, feel free to skip them and focus on the results.

How does leverage work? A mechanical lever can help you lift large objects with less force. In investing, you can spend a certain amount of money and borrow additional money, to buy a larger investment and enjoy the appreciation of the full investment (minus the interest paid on the loan). If the investment goes up in value more than the interest on the loan, you make extra money. If the investment goes up in value less than the interest on the loan, you make less money, or even lose some. In both cases, leverage magnifies the change in the investment returns relative to the interest rate paid.

Let’s review how this works with the most common use of leverage: buying real estate. A common case involves putting a 20% down payment on a piece of property and borrowing 80% of the property value. Note that the financial analysis of real estate investing is significantly more complicated, but this article reviews the concept of leverage alone. Your actual returns of real estate are likely to be very different than shown below because of the other expenses and income from the property.

The following table shows the gain or loss from the investment assuming a 7% interest-only loan. (If the loan involves paying the principal, the effect of the leverage declines over time.)

The return is calculated as follows:

Down payment = the amount you put down to buy your investment
Growth = the percentage growth of the property value
Borrowed = the borrowed amount
Interest rate = the interest rate on the borrowed money

Investment Return =
    [Down payment x growth + borrowed x (growth – interest rate)] / down payment =
    Growth + (borrowed / down payment) x (growth – interest rate) =
    Growth + (80% / 20%) x (growth – 7%) =
    Growth + 4 x (growth – 7%)

Property Growth Investment Return Calculation
20% 72% 20% + 4 x (20% – 7%)
14% 42% 14% + 4 x (14% – 7%)
10% 22% 10% + 4 x (10% – 7%)
7% 7% 7% + 4 x (7% – 7%)
4% -8% 4% + 4 x (4% – 7%)
0% -28% 0% + 4 x (0% – 7%)
-20% -128% -20% + 4 x (-20% – 7%)

Note the following:

  • Every 1% of growth above the interest rate of 7% increases the investment return by 4%.
  • Every 1% of growth below the interest rate of 7% decreases the investment return by 4%.

The benefit : If the property value grows at a rate higher than 7%, the return on your investment becomes significantly higher. This is exactly how homeowners and real estate investors made large gains in recent years up until the recent real estate recession.

The risks : If the property value (plus income minus expenses) grows at a rate lower than 7%, the return on your investment becomes significantly lower. Note the following:

  1. The investment return can be negative even when the property value goes up! For example, when the property value grows by 4%, your return is -8%.
  2. If the property value stays the same, you are at a significant loss. In our example, the return is -28% (0% growth minus 7% interest rate magnified by 4, the leverage multiplier).
  3. With leverage, you can lose more than you invested! In our example, if the property value declines by 20% you lose your full investment and more, for a total return of -128%. You lose your entire investment and need to come up with additional money to cover the interest on the loan.
  4. The length of the investment period also magnifies the returns. For example, if you held a property for 10 years in which its value stayed the same (as happened with real estate in the 90’s), your loss is multiplied by the number of years. In our example, you would lose 28% in one year, resulting in returns of -280% over 10 years. Note again that in practice the numbers are different, because of additional expenses and income from the property.

Summary

Leverage, or borrowing to invest, is a very powerful tool. It can make you rich or send you to bankruptcy. Because of this tremendous power, you would be smart to shy away from leverage in most cases. You should consider using it in rare cases, when even if everything goes wrong you still expect to handle the situation without facing financial hardship. Future articles will analyze certain uses of leverage.

Disclosures Including Backtested Performance Data