Investors Toolkit: The rewards and risks of borrowing to invest

Investors Toolkit: The rewards and risks of borrowing to invest

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific investment advice on a wide range of topics. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Tip of the week: “You could gain some definite advantages if you borrow to invest, but unless you can answer yes to 6 key questions, the risk is probably too great.”

With interest rates remaining near historic lows, borrowing money to invest continues to look like an attractive investment strategy.

This is especially true if you borrow to buy well-established, dividend-paying stocks. For example, you could select from the 21 companies we recommend in the Income-Seeking Investors Portfolio of The Successful Investor newsletter.

Tax advantages are one plus of borrowing to invest

Today, you can borrow for as little as 3.5% if you use your home as collateral. Over long periods, the total return on a well-diversified stock portfolio runs to as much as 10%, or around 7.5% after inflation. So you can expect to earn more than your borrowing cost.


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Borrowing to invest can also be a highly effective tax shelter. You can deduct 100% of your interest expense against your current income. What’s more, the investment income you earn brings three key tax advantages: you get the dividend tax credit on qualified Canadian stocks and you only pay income tax on 50% 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.

6 keys indicate whether you should borrow to invest

As appealing as low rates and the undoubted tax advantages of this strategy are, borrowing to invest does entail added risk. The amount you owe on your investment loan will stay the same, regardless of what the market does, so every dollar your portfolio 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.

That’s why we advise you to consider borrowing to invest only if all six of the following points apply to you:

  1. You are in the top income-tax bracket and expect to stay there for a number of years;
  2. Your income is secure;
  3. You have 10 or more years until retirement;
  4. You follow our low-risk investment advice and stick with quality investments;
  5. 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;
  6. You have already made your maximum RRSP and TFSA contributions.

COMMENTS PLEASE—Share your investment experience and opinions with fellow TSINetwork.ca members

Do you believe borrowing to invest only makes sense if an exceptional investment opportunity arises? Or do you believe it can be used routinely by prudent investors who understand the risks? Or do you avoid it altogether? Let us know what you think.

Comments

  • Two years ago I borrowed against the equity in my home with the intention of investing. By using my home I was able to secure a very low interest rate. I then put the money I borrowed in good dividend stocks to date there is a fairly substantial difference between what I owe on the loan and the value of the stocks. Using the dividends as the value of loan payment it’s basically free money, my average dividend is 3.5 to 4%. When you factor in the tax write off the loan is 1.75%. If rattes remain low I see this continuing to work.

    Sean C

  • Robert

    No mention of margin calls. If an investor borrows on margin he/she should calculate how great a market correction they can finance if there is a margin call without a forced sale at perhaps the bottom of the correction

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