An age old strategy
Borrowing to invest has been around for a long time. The hope is to leverage profits and the risk is leveraging losses.
Taking out a loan to invest means investing other people's money, typically the bank's money. Being risk averse, the bank will want you to dig in your home equity by taking a secured line of credit.
Many view the spread between the cost of borrowing and expected returns from fixed income investments as too small or non-existent to make this worthwhile. So this is mostly done to invest in equities.
If the money is invested in a non-registered account, loan interest is deductible. Investing in stocks or equity mutual funds are also taxed favourably: dividends have lower income tax rates, and units or shares are taxed only at time of disposition at the capital gains tax rate.
If this strategy applies to a registered retirement savings plan (RRSP), the interest on an RSP loan is not tax-deductible, but there will be tax deductions from the contributions.
Over the long term, markets have historically outperformed rising inflation and interest rates. If you have good cash flow to make regular interest and principal payments, this strategy can work: investment returns over the long-term can be significantly higher than loan interest.
Risk capacity and risk appetite
In addition to having the risk capacity to absorb a negative outcome, an investor needs a risk appetite: understanding that there is a possibility to end up poorer if market returns or specific investments earn less than the interest paid on the loan.
One also needs the stamina to stay the course when - not if - there is a market meltdown, as it invariably occurs every few years.
This has to be a long-term strategy, preferably over a period of 10 or 20 years. It is not appropriate if you are close to retirement. This is because you need to manage your market risk and sequence of returns risk, and one approach to tackle both risks is to gradually reduce exposure to equities.
Proceed with caution
Often these loans are made to "kickstart" an investment portfolio. Someone without any portfolio usually lacks investment knowledge, and is more prone to sell quickly if the investment performs poorly, instead of riding market fluctuations.
Getting a loan means renegotiating a home mortgage and converting it into a line of credit that can be used to invest, making the interest on borrowed money tax-deductible. Penalties to break the mortgage should be considered when comparing the potential return to the total cost of borrowing.
If the loan is large, it makes it difficult to repay over the short-term. So future income has to be predictable in order to make it fairly certain that regular loan payments can fit in the budget on an ongoing basis.
It also has to be possible to unwind the strategy without incurring a cavalcade of fees and penalties both on the investing and debt sides.
Magnified gains and losses
Suppose you have $100,000 and you invest it. After two years, the value of your investment declines to $80,000. You sell your units or shares for an investment loss of $20,000 and are left with $80,000.
Now suppose that in addition to this investment, you borrow another $100,000 to invest. Your initial investment is $200,000. You sell your investment after two years and receive $160,000. You repay the loan plus the interest of say, $110,000. You are now left with $50,000.
If everything went well and the investment went up 20%, you would have doubled your gain: $40,000 with leverage compared to $20,000 without.
The downside is larger than the upside because of the interest on the leveraged loan.
Cost of investing
This applies also without leveraging, but you should understand all costs, fees, penalties and commissions of the products you are purchasing. Costs you pay will reduce your investment return. Often investors are not aware or don't understand sales charge when purchasing mutual or segregated funds, including penalties at time of disposition.
When to avoid
If you are uncomfortable or have difficulty managing debt, have a history of poor financial discipline or lack a steady flow of income this strategy is probably not suitable.
Investment loans are not a good solution for emotional or impulsive investors. Avoid any Investment that can give rise to a margin call. It can and usually does occur at the worst possible time and can result in a disastrous outcome.
Also avoid if your future circumstances are hard to predict. If cash flow is prone to change significantly or a large unforeseen expense is possible in the future, being unable to unwind the investment and loan quickly will make this even more challenging.
With the interest not deductible on a RSP loan, a longer term for the loan means that the interest paid may largely offset the value of the tax deduction received from the RRSP contribution.
Shrewd advice
The Ontario Securities Commission has great information on leveraged investing. They recommend investing for the long-term because the risk of leverage declines as the time horizon grows. As well, they suggest paying interest and principal on the loan, not interest only, so the smaller amount owing at time of settlement reduces the chance of loss. Finally, they emphasize the importance of adopting a disciplined investment strategy, avoiding fads and ignoring short-term market fluctuations.
- Important information about the risks of leveraged investing and costs of investing
- Borrowing to invest
- Should I borrow money to buy investments?
