A borrow to invest strategy can boost your long-term gains, but only if you follow these rules. Plus, if you have a chunk of cash, should you pay off your mortgage before looking at a borrow to invest strategy?

Investors sometimes ask what to do with an inheritance or any lump sum: buy stocks or pay off the home mortgage?

From a purely financial perspective, it’s best to pay off the mortgage first before considering a borrow to invest strategy. That way, when you borrow to invest, you get to deduct your interest expense from your taxable income. With interest rates where they are today, this can expand the after-tax return on your initial investment by close to 2% a year compounded. That can give your long-term investment returns an enormous boost, and it’s theoretically risk-free.

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You need to consider behavioural finance before using a borrow to invest strategy

In practice, to weigh the risk of an investment, you need to take behavioural finance into account.

Behavioural finance is the academic study of the way that all-too-human errors can creep into investing decisions. This is particularly relevant to emotion-laden decisions like the sanctity of the family home and the outlook for the stock market. If you fail to take it into account before making serious financial decisions, you put yourself at risk of costly errors.

If you pay off the mortgage then borrow to invest, you’ll probably open a line of credit secured by your home. Some spouses will object to part two of this plan: “I’m not risking our family home so you can play the stock market!” Of course, whether you borrow against your house or not, the stock-market risk is identical. But when a couple owns a home jointly, both partners have to sign off on loans.

However, spousal resistance is just one obstacle to profiting from a pay-off-mortgage, borrow-to-invest plan. Your finances can also suffer if you are simply unsuited to investing with borrowed money. The added stress of risking the family home can lead to bad decisions.

Just remember, you should only invest in stocks when you can make a long-term commitment. But borrowing to invest can weaken your resolve, particularly if you borrow through a line of credit. In that case, it’s easier to abandon your commitment in the next market downturn. You may wind up selling at a loss just prior to the next market rise. 

Six ways to tell if a borrow to invest strategy is right for you

Borrowing to invest 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;
• Your income is secure;
• You have 10 or more years until retirement;
• You follow our low-risk Successful Investor 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.

Three ways to benefit from a borrow to invest strategy

1. Borrowing to invest can cut your tax bill: Borrowing to invest can be a highly effective tax shelter. We are again referring to the fact that you can deduct 100% of your interest expense against your current income. Plus, as mentioned,  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 tax on 50% of your capital gains.
2. Low interest rates favour borrowing to invest: Having low interest rates available to you is one of the best signs that borrowing to invest will make financial sense. Over long periods, the total return on a well-diversified portfolio of high-quality stocks runs to as much as 10% annually, or around 7.5% after inflation. So you can expect to earn way more than your borrowing cost.
3. You can use your dividends to pay your investment loan interest: If you borrow to buy well-established, dividend-paying stocks that meet our Successful Investor criteria these investments will give you regular cash flow from dividend income to pay the interest on your investment loan.

As a general rule, you should be borrowing money to invest in stocks after a drop, rather than when the market has steadily risen for several years. We think you’ll benefit most from this buying opportunity by sticking with the kind of stocks we recommend using our Successful Investor approach.

The cons of a borrow to invest strategy

Borrowing to invest 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 of your portfolio gains or losses will add to, or 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 the investment.

Have you borrowed to invest for the long term but then opted to cash out quickly instead?

Borrowing to invest raises the risk of investing because you’re using money you don’t have and that can turn bad quickly. Still, many investors find it appealing. How have you done it?