Investing is a great way to build wealth over time. But what if you don’t have the capital needed to invest?
Depending on the situation, it might make financial sense to borrow those funds. When these funds are used to invest in assets that are expected to appreciate in value over time, borrowing might be a sound financial decision.
Let’s take a closer look at all the concepts of borrowing to invest to help you decide if this is an avenue worth taking.
Key Points
- Borrowing money to invest can result in a profit if your rate of return is higher than the cost of borrowing.
- There are risks to understand when borrowing money to invest, such as overleveraging yourself or investing in a high-risk vehicle.
- Several loan types are available to provide the funds needed to invest, such as margin accounts and home equity loans.
Can You Borrow Money To Invest?
Yes, you can borrow money to invest in certain assets, stocks or opportunities. In fact, if you’ve obtained a mortgage to buy a home, you’ve actually borrowed to invest in property!
Many individuals and businesses may also require an investment loan to help invest in a tangible asset, while others may require it as part of their retirement plan.
You can get a specialized investment loan from most banks. For instance, CIBC offers a “CIBC RRSP Maximizer Loan” to help Canadians fill up their RRSP and take advantage of larger tax refunds.
Types Of Loans You Can Use To Invest
There are several loan types to consider as a source of funds to use for investment purposes:
Margin Accounts
A margin account is a type of brokerage account that allows you to borrow money within for the purpose of buying stocks or other investment products. When these borrowed funds are used to invest, the interest paid is tax-deductible.
Brokerages that offer margin accounts lend up to a specific percentage of the account value at a certain interest rate. Margin account interest rates typically range between 5% to 10%, though the exact rate depends on the brokerage.
It’s important to note that you’ll need to keep a certain amount in your account to be used as collateral. Finally, if your investment experiences high losses, the broker may demand you deposit additional funds — this is called a “margin call”.
RRSP Loans
As mentioned above, many banks offer specialized investment loans that you can use to contribute to your RRSP. This loan can help you maximize your RRSP contribution room and save on taxes if you don’t have the cash at hand to make a contribution right away.
These loans generally come with lower interest rates than a regular personal loan and terms that range from a few months to several years. However, keep in mind that the interest payments on an RRSP loan are not deductible on your income tax return.
Personal Loan Or Line of Credit
Funds from a personal loan or line of credit can also be used to invest. The interest may also be tax-deductible, though the specific use of borrowed money determines tax deductibility. More specifically, to be tax-deductible, the interest from an unsecured personal loan or credit line must be incurred for the purpose of earning an income from a business or property. However, the higher interest rates that come with these sources means you’ll need a greater return on your investment for it to be worth it.
Home Equity Loan
If you own a home and have at least 20% equity built up in it, you may be able to borrow against that equity and use the funds to invest. A home equity loan is secured against your property, which means your home acts as collateral for the loan. As such, the risk for the lender is lower, thereby allowing you to take advantage of a higher loan amount and lower interest rate compared to other loan types.
To repay the loan, you’ll make regular installment payments over the loan term. Like other loan programs, the interest you are charged on your home equity loan can be tax-deductible and therefore reduce your taxable income.
Keep in mind that your home is at stake if you default on the loan, so make sure you are disciplined and capable of keeping up with your loan payments if you choose to take this route.
Reasons To Borrow Money To Invest
There are several reasons why Canadians borrow money to invest, including the following:
To Maximize Returns
While you might make a little bit of money on deposits sitting in a savings account, the returns are extremely small. Instead, consider investing in a Tax-Free Savings Account (TFSA), Exchange-Traded Fund (ETF), or some other investment account that has the opportunity to make you much higher returns.
Of course, the returns you gain are highly dependent on your risk aversion, the stocks you invest in, and the time you leave your investments to grow. Generally, the longer you leave your money in an investment account, the higher your returns will be.
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To Take Advantage Of Tax Benefits
Certain investment vehicles allow you to reduce your tax burdens, including those that involve investing in Canadian firms and retirement accounts. For example, if you lose money, you can lower your income tax by claiming capital losses to offset capital gains. If the cost of borrowing is less than the tax savings you’d realize, it might make sense to borrow to invest.
Advantages Of Borrowing To Invest In Stocks And ETFs
Stocks and ETFs are common investment assets among Canadians. If you don’t have the money readily available to invest, borrowing might be an option.
Here are some benefits to consider when it comes to borrowing to invest in stocks and ETFs:
- Deductible Interest Expense – You may be able to reduce your regular income when you file your taxes by deducting your interest expenses from your investment. In turn, this will lower what you owe in taxes and potentially save you a lot of money. Keep in mind that the funds borrowed must be used for the purpose of earning income from a business or real estate.
- Lower Tax Rates On Dividends From Canadian Companies – If you regularly collect dividends from investments made in Canadian stocks, the tax rate your dividends are taxed at will be lower than other investments.
- Dividend Tax Credit On Gains – Dividends from non-registered account investments must be declared as income when you file your taxes, but you can claim a dividend tax credit. Since only 50% of capital gains up to $250,000 are taxable (and 66.7% of gains over $250,000), this can help reduce your tax obligations.
- Stock Investments Are Easy To Sell – Since investments in stocks are liquid, selling them is much faster and easier compared to other investment types where your money is locked in or much more difficult to convert into cash.
- Build And Grow Your Wealth — Investing is a great way to establish and build your wealth over the long term. If you don’t have the money to start investing, borrowing can help you get into the world of investing and building wealth earlier, instead of waiting until you have a little extra cash to invest.
Disadvantages Of Borrowing To Invest In Stocks And ETFs
Along with the potential upsides of borrowing money to invest come a few important drawbacks to consider:
- Increased Leverage — Borrowing money to invest increases your leverage. You’ll still have to repay your investment loan, no matter what happens with your investment. While you may have plenty of money to make your loan repayments if your investment does well, you could find yourself struggling to pay back the loan if your investment does poorly.
- Risk Of Lower Earning Rate — Depending on the type of investment you make, your rate of return could fluctuate. If this expected return dips below the interest rate you’re paying on your investment loan, you’ll lose money.
- Risk Of Losing Your Assets — If you use a home equity loan or other type of financing that uses a valuable asset to back the loan, you may be at risk of losing it if you fail to repay your loan.
Borrowing To Invest In Dividend Stocks
By borrowing money to buy non-registered Canadian dividend stocks, all the interest charges on the loan can be deducted from your taxable income. This makes the cost of borrowing a bit cheaper. You’ll likely come out ahead when you compare the cost of borrowing to potential returns.
For instance, if you borrow $5,000 at a 5% interest rate on a 3-year term, your monthly payment would be approximately $150 a month. The total interest over that term would be around $395, which can be deducted from your taxable income.
Should You Borrow To Invest In An RRSP?
When borrowing to invest, it’s all about ensuring that the returns outweigh the cost to borrow. And investing in tax havens, like a Registered Retirement Savings Plan (RRSP), is a great way to make the most of borrowed funds when investing. But in a non-registered account, you can potentially claim capital losses if an investment does poorly.
Any contributions you make to your RRSP account before the annual contribution deadline is deductible on your income tax return. As such, you can reduce your taxable income, and therefore reduce the amount you pay in income taxes.
Should You Borrow To Invest In A TFSA?
While you can take advantage of tax deductions for your RRSP contributions, the same does not apply with a TFSA. If you borrow money for the purposes of investing in a TFSA, you won’t be able to deduct your contributions for income tax purposes. As such, you’ll want to carefully crunch the numbers and weigh the cost of borrowing versus your investment gains.
That said, any amount contributed to your TFSA as well as any income earned in the account (for example, investment income and capital gains) is generally tax-free, even when it is withdrawn.
When To Avoid Borrowing For Investments
Taking out a loan might not always make sense. Here are some scenarios in which it may not be worth it to borrow to invest:
- You’re In A Very Low Tax Bracket — One of the biggest benefits of borrowing to invest is the tax savings it provides. For example, if you can deduct your interest, you can reduce your taxable income and lower your taxes owing. However, if you already fall in a low tax bracket, you wouldn’t be saving much, if anything at all.
- You Have Unstable Employment — If you work on contract, part-time, or seasonal hours, your income may not be predictable enough to ensure that you’ll have the income needed to continue paying your loan off.
- You Often Make Rash Decisions — When markets drop, how do you typically react? If you’re likely to make hasty decisions, such as selling everything out of fear of prices dropping even further, you risk wiping out any benefits of taking out a loan to invest.
- You Already Have High Debt — If you’re already maxing out your income to cover current debts, your risk of defaulting on your loan payments is higher.
- You Have A Low Risk Tolerance — Borrowing money to invest produces leverage. If you aren’t comfortable with risk, borrowing money to invest might not be a good idea.
Investment Traps To Avoid
There are several investment traps to avoid when investing. Ultimately, it comes down to “behavioural biases” that predispose you to think or behave a certain way when you invest.
Overconfidence
Being confident when investing may be a good thing, but within reason. You need to balance this confidence with a little precaution to avoid jumping into a potentially risky investment without giving it too much thought. Being overconfident with your investments could stand in the way of implementing the appropriate safeguards required to protect your capital.
Anchoring
Anchoring involves holding on to a specific idea of a stock price that can eventually cause you to make bad decisions in the future. For example, this can happen when you purchase a stock at a specific price and rely on that price when making future judgments.
When this happens, you may hold onto the stock for too long because you’re essentially “anchoring” on the higher price of today rather than the price you bought it for. In this case, instead of holding onto the stock, it probably should have already long been sold off.
Herd Behaviour
If you see many other investors jumping on the bandwagon of a certain stock, you may suffer what’s known as “Fear of Missing Out” — or FOMO. This may cause you to follow what other investors are doing without doing much research yourself. You may put yourself at great risk, especially if the stock you end up investing in is high-risk and has a great potential to tumble.
Keep your emotions, thoughts, and behaviours in check when handling your investments. Always keep in mind that investing involves an array of possibilities.
Final Thoughts
The decision about whether to borrow money to invest all comes down to the cost of borrowing versus the returns you expect to generate from your investment. Before borrowing, do the math to calculate how much you stand to earn from your investment. Then, compare this to how much it will cost you to take out a loan to access capital to invest.
