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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.
The key is whether or not the anticipated returns are much higher than the cost of borrowing. There are other factors involved as well, such as the type of investment you make and your short- and long-term investment goals.
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.
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, invest in a TFSA, RRSP or some other investment account that has the opportunity to make you much higher returns. Of course, the returns you gain are highly dependant 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 Build Credit
In the process of maximizing your returns, borrowing money to invest is also a great way to start building a good credit profile. That is if you handle the loan responsibly and pay it back on time. Considering your payment history usually accounts for almost a third of your credit score, the payments you make to repay the money you borrowed to invest can positively affect your score.
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. 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 exchange-traded funds (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 can effectively 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.
- 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 are taxable, 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.
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 $390, which can be deducted from your taxable income.
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How To Use Your Home Equity To Invest?
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.
Like other loan programs, the interest you are charged on your home equity loan can be tax-deductible and therefore reduce your taxable income.
It’s important to 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.
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 is a great way to make the most of borrowed funds when investing.
Another smart way to borrow to invest is by taking out an RRSP loan. This involves using all of your allowable RRSP contribution room and deducting it from your taxable income within the same year that you make your contributions.
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 write off the interest payments from your taxes. As such, you’ll want to carefully crunch the numbers and weigh the cost of borrowing versus your investment gains.
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. 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 rash 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.
Types Of Loans To Use To Invest
There are several loan types to consider as a source of funds to use for investment purposes:
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 they can vary from one brokerage to the next. When these borrowed funds are used to invest, the interest is tax-deductible.
It’s important to note that you’ll need to keep a certain amount in your account to be used as collateral, which usually ranges anywhere between 30% to 100% of market value.
Personal Line of Credit
Funds from a 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. For instance, borrowing money against the equity from a rental property may not always qualify for a tax-deductible if the money is used for personal reasons.
On the other hand, interest for money used to finance an investment property may be deducted come tax time if the funds are used for things such as a renovation, down payment, or other rental property costs.
Can I claim investment losses?
Should I borrow to invest if I’m in a low income bracket?
Are there any investment traps I should avoid?
The decision about whether or not 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 compared to how much it will cost you to take out a loan to access capital to invest.
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