The Self-Funding Loan Disorder

Geoff Cook - CFP, CHAIP

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Leverage is a double edge sword. It can be of great use to build and accumulate wealth, or it can implode your financial balance sheet.

The situation I'm going to discuss in this post is specific to a situation I have been faced with numerous times. The program I will be discussing often known as a "Self-Funding Loan" was prominent a few years ago when we had steady years of positive growth in the investment markets and regulation towards lending wasn't as tight as it is today. There has been especially a large amount of cases in the city of Barrie, and surrounding area where I do most of my business but I have also dealt with people as far as Ottawa in a similar situation.


What is a self funding loan?

As the name suggests, people were convinced to proceed in a program where they would borrow money to invest. They invested the money in mutual funds. The mutual funds would produce a yield (income) in the form of interest and dividends, which would be paid on a monthly basis to the investor who could then use the income to pay for their loan.

Sounds great right?

In other words you could borrow money to invest and it wouldn't even cost you anything. The other great part was that the investment advisor claims they are great investors and your investments will always make money and your account will always go up.

I have created a diagram below to further illustrate the program.

 


As you can see this is pretty straight forward, and sounds like an awesome program.

"You mean it doesn't cost me anything, there is no risk, and one day I will end up with a bunch of free money??"...Sign me up!

Now, unfortunately as the old saying goes "If it sounds too good to be true, it usually is". The unfortunate problem with this program is those dollars that were paid to the person as "interest and dividends" were actually mostly what we call "Return of Capital" or in simple terms - your own money back.

In other words, the money that people are receiving on a monthly basis is not actually investment returns, they are just selling a portion of their mutual funds to pay for their loan.

Here is the real illustration.

 

The trouble is that if we are not making our own loan payments and we are selling investments on a monthly basis to pay for our loan, then we depend on our investments to consistently generate a return on a monthly basis in order for the leverage program to not go under water.

Furthermore, negative returns are much more powerful than positive returns.

For Example

If you had $100,000 and lost 50% your account would be worth $50,000.
If you then earned a 50% return on your account it would then be worth $75,000.

In the cases I have seen, the cost of the loans today are around 5%. This means that if markets stay flat, their accounts will be down 5% and they will need to earn a rate of return of 5.26% just to break even.

Add to this a volatile market, and the chance that in any given month the account could be down 1-5% and all the sudden we are playing a vicious game.

The other difficulty is that if the accounts need to earn at least 5.26% to break even that means we need to invest the money in something that has potential to earn that and more because if the account is underwater breaking even won't get it back above water.

Since the money is leveraged we need to be careful about how we invest the money and can't be very aggressive because as we know markets seldom act rationally, and the chances of making money in the short term on an aggressive investment are slim. Needless to say our investment strategy for this program is conservative with the potential to do well in a rising market but substantial protection in a falling market.

I have spent some time talking about the problem, now I would like to talk about some solutions we have come up with to help these accounts.

VARIOUS OPTIONS FOR DEALING WITH SELF FUNDING LEVERAGED INVESTMENT ACCOUNTS:

1) Pay off the investment loan. This may result in a balance owing on the loan with no investments remaining but reduced carrying costs.

2) Stop the Systematic Withdrawal from your investments, or the distributions from your leveraged account and pay the loan costs from cash flow or alternative sources if available. This will increase the potential for your leveraged account to recover faster.

3) Pay down the principal of the loan and interest costs from cash flow.

4) If interest costs and loan principal cannot be paid by cash flow can the withdrawals be reduced?

5) Are other assets available to pay down the loan?

6) Evaluate investments to determine if they are the most appropriate for individual circumstances.

We have seen a number of different scenarios that are slightly different. The main objective of this post is to raise awareness of the problem, and offer some simple solutions.

Please let me know if you have any further questions. You can email me directly - geoffcook@infinitefinancial.ca

Please note: We are by no means reccomending leverage. There are different ways to utilize leverage and there can be potential benefits as mentioned it is a double edged sword. If you are considering using leverage the first thing you need to do is review this document - Leverage Risk Disclosure

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When dealing in financial matters, you are urged to consult an advisor for legal, tax or investment advice. Every effort has been made to present information in a clear, exacting manner. However neither the publisher nor the authors can be held responsible for any losses incurred due to the actions of any individual as the result of this post or any errors or omissions contained herein.

Infinite Financial places mutual fund transactions through Banwell Financial Inc. and Life Insurance transactions through Bridgeforce. To learn more about these relationships - click here

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