Debt is a lifelong reality for most people. Today’s young investor will probably start out with student loans and credit card debt, graduate to a car loan, then mortgages for a family home or cottage. But although most people are comfortable with debt, using leverage as part of an investment strategy still makes the same clients nervous.

Still, there are advisors who make leverage an important part of their business. With a good plan and the discipline to stick to it, they say, investment lending is — ironically enough — one path toward living debt-free, so that investors can start saving, not only for retirement but also the other big things along the way.

Investment leverage works on the principal that an investor can generate more growth by investing borrowed money than it costs for him or her to finance the debt. While it may be simple in principle, it is far more complex in execution. For one thing, there is an important element of risk. Using leverage amplifies market exposure and returns but it also amplifies losses in the event the market takes an unexpected turn downward.

It’s an “all in” strategy — a long-term commitment — which is why Francis Brouillette, an advisor with Mica Capital Inc. in St-Bruno-de-Montarville, Que., goes through a rigorous process to select and prepare clients for using leverage. “It’s not for everyone,” he says.

But it appeals to enough people that Brouillette has built his practice, one of the largest in the Mica advisory network, by helping clients use the equity in their portfolios and their homes to increase their returns — and to pay off debt and grow their savings faster. Brouillette manages 250 households and some $25 million in assets. About a third of his clients use some form of leverage.

Candidates for lending strategies must have equity in their homes or have maximized their RRSPs. They borrow against their assets with a lender such as TD Canada Trust, AGF Trust Co., Manulife Bank or B2B Trust, and invest the proceeds in portfolios from a list of vehicles approved by the lender — fixed-income, dividend-paying equities, mutual funds and segregated funds. The proceeds finance the debt and build equity. Brouillette has his clients continue to make payments, as they did before employing leverage, on their mortgages or savings plans, so their monthly budgets do not change significantly. Between the returns on the investments and continued contributions, the client is in a position to pay down the debt and start saving significantly sooner.

Deciding for whom leverage is right has more to do with the client’s emotional maturity than his or her portfolio. Emotions tend to feed the wrong impulses when it comes to using leverage, setting emotional investors up to fail. When markets are charging skyward, these investors want to use leverage to get in — often late — on a trend, only to pay an inflated price. If the market tanks, they want to get out, when they should be doing the opposite. The key to using leverage effectively is discipline.

“Any one using leverage should be thinking about decades, not months,” explains Jeremy Bird, senior managing director at TD Canada Trust in Toronto.

The first thing Brouillette does when he addresses leveraged investing with clients is to clean up their finances. The most important step is to create a budget and consolidate existing debt. This budget has to cover everything, or it will be very difficult for the clients — usually couples — to stick to a long-term strategy if they are not honest with themselves and each other going in.

“People are uncomfortable talking about money,” says Brouillette, “even more than discussing sexuality.” But it must be done.

Brouillette likes to create a financial cushion so clients can deal with unforeseen expenses, such as car repairs or replacing an appliance, without having to rely on credit.

When it comes to investing, “the No. 1 priority is to protect the principle,” adds Vincent Provost, an advisor with Peak Financial Services Inc. in Montreal, who has also built leverage into his practice. Provost works closely with Jean-Louis Bowes, a mortgage broker with Multi-Prêts Courtier Hypothécaire, to work with clients who want to use the equity in their homes.

@page_break@“People have the false impression,” Provost says, “that once the house is paid for, they are taken care of.”

Provost has $27 million in assets under management and has been with Peak for the past nine years, following a stint working in the banking sector. Provost and Bowes cite Fraser Smith’s book on how to make a mortgage tax deductible, The Smith Manoeuvre, as the jumping off point. But it is hardly the be-all and end-all, they say, because leverage is a lot of risk to take on for the sake of avoiding some taxes. Investors have to understand the big picture.

In terms of the mechanics of leveraged lending, the collateral or assets against which the client has borrowed are held in trust. While the underlying asset belongs to the investor, the lender essentially has custody of it.

Since September, both TD Canada Trust and AGF Trust have canceled their 100%-leveraged products, in which the loan completely finances the purchase of investments and those investments then work as collateral. “Not because we were losing any money on them,” says Bird, “but because aggressive leverage will no longer seem suitable.”

Mario Causarano, president and chief operating officer of AGF Trust in Toronto, said in a statement: “In light of the current economic environment, and in order to continue to prudently manage our business, we are scaling back on some initiatives but continue to offer competitive loan options to financial advisors and planners.”

Both TD Canada Trust and AGF Trust continue to offer $1-for-$1 and $3-for-$1 investment loans in which the lender puts up $1 and $3, respectively, for every $1 of collateral. While the ceiling varies from lender to lender, TD Canada Trust’s $3-for-$1 has a maximum of $300,000.

It is up to the advisor to make sure his or her client understands the consequences and is suited to the strategy at a personal level. “From the perspective of the lender, every case is assessed on an individual basis,” Bird says of the credit approval process at TD Canada Trust. While lenders are discriminating — even conservative — they assess the client’s credit, not whether acquiring debt suits their investment style or their personality. That is done by the advisor. The fund dealers’ compliance department also has to approve the use of leverage.

The Mutual Fund Dealers Association of Canada — risking erring on the side of caution — released Notices 69 and 70 in April and May 2008, respectively, addressing suitability of leverage for retail clients. The MFDA outlined guidelines for disclosing the level of risk associated with the strategy — primarily that, in the event the market contracts, clients could end up owing more then they borrowed if the collateral asset shrinks in value.

While it is the advisor’s job to explain the risk associated, it is also the advisor’s job to present opportunities. Leveraged investing has its advantages. For one thing, in Canada, the interest on borrowing for investment purposes becomes a tax deduction, a distinct advantage.

Further, in a working paper published in June 2008 by the U.S. National Bureau of Economic Research, authors Yale professors Ian Ayres and Barry Nalebuff found that investors can diversify across time — in addition to asset class and geographical region — by using leverage to increase their market exposure when they might not otherwise have as much in the markets.

There is one last test for suitability that Brouillette uses. Before he and his clients implement any leverage strategies, Brouillette sends the clients home to let it “stew” for a few days. He tells them to think about it as if it were already implemented. Some clients, previously dazzled by amplified returns, then change their minds.

“If, knowing the risks of leverage,” Brouillette says, “they cannot sleep at night, then they should not be using leverage.” IE