Borrowing to invest in dividend stocks may be a good decision if you meet these six criteria

Borrowing to invest can make sense for some investors under certain circumstances. We think you’ll benefit most from this buying opportunity by sticking with high-quality stocks. That suggest borrowing money to invest in the stock market works best when you focus on dividend-paying stocks, which give you regular dividend income and provide cash flow to pay the interest on your investment loan.

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Borrow money to invest and you could benefit in these three ways:

• Low interest rates favour borrowing to invest: When borrowing money to invest in the stock market, having low interest rates available to you is one of the best signs that it will make financial sense. Over long periods, the total annual return on a well-diversified portfolio of high-quality stock market investments runs to as much 7.5% after inflation.
• You can use your dividends to pay your investment loan interest: If you borrowing money to invest in the stock market, buying well-established, dividend-paying stocks, like those we recommend in our Successful Investor newsletter, should give you regular dividend income and cash flow to pay the interest on your investment loan.
• Borrowing to invest can cut your tax bill: Borrowing to invest in dividend stocks can be a highly effective tax shelter. That’s because you can deduct 100% of your interest expense against your current income.

Borrowing to invest in dividend stocks can pay off—but it’s not without risks

As we indicated, over long periods, the total return on a well-diversified portfolio of high-quality stocks runs as much as 7.5% after inflation. So, in addition to the tax advantages, you can expect to earn more than your borrowing cost.

But borrowing money to invest in the stock market is not without risks, including the risk of increasing your leverage. The amount you owe on your investment loan will stay the same, regardless of what the market does, but every dollar your portfolio gains or loses will come out of your equity. In addition, if you take out a variable-rate loan, the interest rate you pay could eventually rise above the return on your stocks.

On the other hand, borrowing to invest can be a highly effective tax shelter. As mentioned, you deduct your interest expense against your current income. But the investment income you earn comes with three key tax advantages: you get the dividend tax credit on qualified Canadian stocks and you only pay income tax on half of your capital gains. In addition, you are only liable for capital gains when you sell; if you buy high-quality investments, you’ll wind up holding some of them for as long as you live. It’s a great tax-deferral technique. And it’s perfectly legal.

Still, borrowing to invest in dividend stocks only makes sense if all six of the following apply:

• You are in the top income-tax bracket and expect to stay there for a number of years borrowing money to invest in the stock market can pay off;
• Your income is secure;
• You have 10 or more years until retirement;
• You follow our low-risk investment approach;
• You have the kind of temperament to sit through the inevitable market setbacks without losing confidence at a market bottom and selling out to repay your loan;
• You have already made your maximum RRSP contributions.

Bonus tip #1: Invest in dividend stocks to maximize your long-term portfolio returns

Some good companies reinvest profits instead of paying dividends. But fraudulent and failing companies hardly ever pay dividends. So if you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks.

We focus on dividend stocks that have industry prominence, if not dominance. Our reasoning, besides brand recognition, is that major companies can influence legislation, industry trends, etc. to suit themselves. Minor firms can’t do that.

If you stick with top-quality high dividend yield stocks, the income you earn can supply a significant percentage of your total return—as much as a third of your gains.

Dividend stocks are an important contributor to your long-term gains, and dividend-paying stocks tend to expose you to less risk than non-dividend-payers. That’s why the majority of your stocks should be dividend-payers at all times. As you get older and closer to retirement, you should raise the proportion of dividend-paying stocks in your portfolio, to cut risk and improve the stability of your investment results.

Bonus tip #2: Use our three-part Successful Investor approach to make better stock selections. That’s key when borrowing money to invest in the stock market

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Warren Buffett has referred to leverage as addictive. What are your thoughts?

What is your opinion on borrowing to invest in the stock market? Do you think it’s worth the risk under the right conditions?

This article was originally published in October 2010 and is regularly updated.