Borrowing Money To Invest

Is borrowing to invest worth it?

Borrowing to invest can enable an investor to amplify their returns by leveraging their capital invested. But is borrowing worthwhile?

You can come up with different results to support or oppose borrowing to invest, depending upon the time period you pick. But if we go way back to 1935, the long-term average prime lending rate in Canada has been about 6.6%. Canadian stocks as represented by the TSX have returned 9.5% per year. The S&P 500 in the U.S. has generated about an 11% annualized return including reinvested dividends.

At first glance, borrowing to invest in stocks seems to make sense. But most investors would not invest 100% into stocks. Adding in bonds and other fixed-income would reduce returns. Deducting investment fees and transaction costs would reduce returns. Introducing potential bad investor or advisor behaviour, like buying high or selling low, could also limit the net benefit.

Real estate is a much more difficult asset class for which to identify historical returns. This is in large part because the return is based not just on price appreciation, but also net rental income. Rents are not tracked the same way historical dividends are for stocks.

Real estate may be a better investment to borrow to invest in than stocks, bonds, mutual funds and ETFs. There are a few reasons for this. One of the main ones is that real estate is less liquid. If stocks fall, you can panic and sell with the push of a button. Selling real estate requires a lot more work and that can be a deterrent from knee-jerk reactions.

Real estate is also less volatile. Stocks fall roughly three years out of every 10 years, whereas real estate generally appreciates in value. As such, it is a more stable asset class.

Finally, rents generally reflect the cost of ownership plus a profit for the landlord due to supply and demand, and the income appreciates over time, tracking reasonably well with inflation. There can be significant differences in the rent to market value ratios in different cities, with some areas in Canada right now relying much more on capital appreciation than income. Low rents and high market values should be a red flag for local investors, but the economics of owning a rental property are generally well suited to leveraging a purchase with debt, regional anomalies aside.

Borrowing to invest can help increase returns if you time things right, but market timing may be as much luck as it is skill. Leveraged investing, whatever the investment purchased, is best done over the long run as opposed to for short-term gain. Market efficiencies have a way of punishing the average short-term investor and rewarding long-term investors in the process.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.