Risk tolerance key to investment loans

Generally speaking, debt is a bad thing. Sure, there are “good” kinds of debt, such as mortgages, but no matter how you slice it, debt is a liability, and evidence suggests that Canadians are carrying more than ever.

A StatsCan study from last month found that from 1999 to 2005, the accumulated personal debt of Canadians rose 43% to $760 billion. This growing pit of debt Canadians keep digging doesn’t bode well for savings.

Still, advisors have numerous options for trying to turn a negative into a positive for investors, ranging from low-interest RSP loans to long-term tax-advantaged mortgage solutions. Industry professionals warn, though, that while many of these solutions have shown proven results, advisors need to do their homework in both gauging their clients’ tolerance of risk and developing a strong debt management plan.

The only hard-and-fast rule with investment loans is they should magnify the borrower’s returns on an investment. They can magnify gains substantially by allowing an investor to keep his or her current base of assets in addition to gains on borrowed money. But the flipside can also be true — magnified losses. An investor risks losing only on the investment but also the principal and interest of the loan.

After understanding that, the advisor must navigate the murky waters of debt management and the various ways debt can be used to benefit a client. There is discussion in the industry about good debt vs. bad debt. Generally, debt that doesn’t have deductible interest is considered bad, and debt that does is good. Leverage loans can basically be divided into these two categories.

Categorizing good and bad debt can be complex. For example, interest on an RSP loan is not tax deductible, but it can be an effective method to make RSP payments where the tax is deducted on the contribution. Generally, this strategy is applied for the short term, where the loan is paid off quickly, but John Bennett, executive vice-president at AGF Trust Company, says even this is questionable now with low-interest RSP loans that can be carried over a longer term and invested.

Advisors have to know their clients and the options available before recommending an investment loan. Bennett points out the reality of the marketplace today is that advisors have to be as good at managing debt as they are at managing assets. He adds that the difference in client goals is vast, but as a starting point, advisors can develop some general criteria for what type of client may benefit from a loan.

“You have to understand your client’s overall situation,” Bennett says. “Every situation is different. You’re going to have a wide range of applicants, but very generally, the ideal client would be somebody who has their debt levels under control. They have income but haven’t been able to accumulate assets or investment.”

AGF is currently testing an educational product for advisors it calls a Growth Propulsion System, which will provide RSP and other lending solutions.

Jack Courtney, assistant vice-president of Investors Group’s advanced financial planning, agrees with Bennett that there is no way to identify a client who could use a loan without having a profound understanding of his or her investment needs. He stresses, though, that risk tolerance is a key factor — even if an advisor has a client who might benefit from a loan, that client has to be comfortable with the risk involved. Courtney pointed out that IG currently offers its advisors risk-tolerance assessment tools so they can determine how susceptible their clients are to risk.

He says, with non-RSP loans, for example, a client has to be confident in the decision to take a risk. “This is not a product. This is a strategy for high-risk-tolerant clients — [it] certainly has the potential for risk, so you need to focus on suitability. Over the short-term, with volatility in the markets, [you] have to have had the conversation about the downturn,” he says.

“I’m surprised when any client is willing to consider it,” says Graeme McPhaden, a CFP affiliated with Armstrong and Quaile Associates. “Ninety-nine per cent of my clients are not comfortable with this type of program.”

McPhaden has been specializing increasingly in investment loan scenarios, particularly debt-conversion techniques like the Smith Maneuver. He is adamant that while he’s done the math and research to find that many of the loan techniques will work, finding a client that will be open to them can be difficult, and advisors and clients have to be willing to borrow for the long haul in order for it to work.

“First of all, if they can’t manage their debt, I will rule them out right away,” he says. “[They must have] good control of their cash flow and manage their debt well. If they have no clue what they are spending, then forget it. They can’t be a mess; they need to understand why they are borrowing.”

McPhaden says if you do find a client with good cash flow and a willingness to stick to a long-term plan, you need to ensure he or she gets the money from the right source. Avoid margin-call loans and take note that clients willing to convert mortgage debt should find a lender that does re-advanceable loans.

For investment loans in general, McPhaden says he’s had good success with the loan programs from AGF and Manulife Bank, and he’s found most major banks and institutions open to clients looking for a re-advanceable mortgage.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(01/24/07)

Mark Noble