Borrowing to invest is a strategy that can amplify your financial gains but also carries significant risks. Before diving into this approach, it’s crucial to understand the key considerations that can impact your financial health. Here are four essential points to keep in mind when contemplating borrowing to invest.
1. Assess Your Risk Tolerance
Borrowing to invest inherently increases your financial risk. This strategy, known as leveraging, can magnify both gains and losses. If the investment performs well, the returns can be substantial. However, if the investment underperforms, you are still obligated to repay the loan with interest, which can lead to significant financial strain.
Tony Maiorino, head of the RBC Family Office Services team, emphasizes the importance of aligning this strategy with your risk tolerance. "Borrowing is something people do every day — for a car, a home, or a vacation property," he says. "The question is, should you borrow to invest money in the markets? The answer to that question is much more complex". Therefore, it's crucial to evaluate your comfort level with potential losses before proceeding.
2. Understand the Costs Involved
The cost of borrowing is a critical factor that can affect the profitability of your investment. Interest rates, loan fees, and repayment terms all play a role in determining whether borrowing to invest is a viable option. High-interest rates can erode potential gains, especially if the investment does not yield the expected returns.
For instance, if you take out a loan at a 6% interest rate, your investment must generate returns higher than 6% to be profitable. Considering the volatility of markets, this can be a challenging benchmark to meet consistently. It is possible that this technique could be successful if it is possible to obtain a loan at an interest rate that is lower than the anticipated return on the investment. It is not suggested, however, to invest a loan with a high interest rate in volatile markets such as stocks or derivatives, where there is a large chance of loss.
3. Evaluate the Type of Loan
Different types of loans come with varying terms and conditions. Personal loans, home equity loans, and margin loans each have their own set of advantages and drawbacks. Personal loans are typically unsecured and come with higher interest rates, while home equity loans are secured against your property and may offer lower rates but put your home at risk.
Ann Bowman, head of Canadian Private Banking at RBC Wealth Management, suggests that borrowing against a home equity line of credit (HELOC) can be a good move for those with substantial home equity. "It’s a good move for people with a lot of wealth tied up in their home, and who feel they can pay off the loan in a time frame that aligns with their financial plan". However, this option may not be ideal for individuals with inconsistent income streams.
4. Consider the Tax Implications
Interest on loans used for investment purposes can sometimes be tax-deductible, which can lower the overall cost of borrowing. However, this benefit typically applies only to investments in taxable accounts and not to tax-advantaged accounts like RRSPs or TFSAs. Understanding the tax implications of your investment strategy is crucial for optimizing your financial outcomes.
Maiorino explains that deductible RRSP contributions can be used to reduce personal income tax, and the tax refund can then be used to repay a portion of the loan. "If you can afford it, and can make the payments, it’s a no-brainer," he says, highlighting the long-term benefits of starting early with retirement savings.
Borrowing to invest can be a powerful strategy for increasing your investment capital and potential returns. However, it also comes with significant risks and costs that must be carefully evaluated. This approach is best suited for experienced investors with a high tolerance for risk and a solid financial position. Before proceeding, consult with a financial advisor to ensure that this strategy aligns with your overall financial goals and risk tolerance.
