Traditionally, we look at loans as nothing more than necessary evil. We use them when we don’t have enough income to cover our regular expenses or to make a large purchase when we want it, rather than saving money and waiting as our grandparents did. This enables us to enjoy life today, rather than when we can afford it. But loans can be a dangerous trap. In North America average consumer owes over $50,000 dollars. Many people become addicted to easy loans which eventually become unmanageable. I have friends who can barely make minimum interest payments on their credit cards each month.

But there is another, less well known aspect of loans. With proper financial planning they can be a powerful tool for wealth creation and income generation. First, let’s look at Leveraged Loans. A leveraged loan is simply a loan taken out for investment purposes. Here is an example. If you take out a $100,000 loan at 5% and invest this money in a balanced account earning an average rate of return of 8%, in ten years your investment will grow to $215,892. Every year you will have to pay $5,000 in interest, but because this interest expense is tax deductible, your net out of pocket expense will be only $2,850 (assuming a 43 % marginal tax rate). After ten years you can repay the loan, and you will have $115,892 left.

How does it compare against doing it the traditional way? If you invest the same out of pocket amount of $2,850 for ten years in the same account earning the same rate of return, you will have only $44,590 accumulated at the end of year ten. The difference is impressive, and the key to this strategy is interest deductibility for tax purposes. Another area where loans are used to increase wealth is retirement income maximization. It is possible to accumulate wealth on a tax deferred basis inside a whole life or a universal life insurance policy. The problem is that when a withdrawal is eventually made there will be tax consequences.

One way to avoid it is to take out a loan secured by the policy cash value instead of making a direct withdrawal. Loan proceeds are not taxable and they are not included in income which is used to determine a person’s eligibility for government benefits such as Old Age Security and Guaranteed Supplement. This strategy known as Insured Retirement Program (IRP) is commonly used by high earning individuals and in many cases can double the retirement income compared to traditional investment strategies. As you can see, loans can be effective if utilized properly and prudent financial planning is involved.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.