The article “What are the pros and cons when borrowing money to invest?” was originally published in Financial Post on April 6, 2023. PHOTO BY GETTY IMAGES/ISTOCKPHOTO.
You need a high risk tolerance, low investment fees and a long time horizon to make it worth considering
Q: ” My wife Karen and I are 45 years old and each of us earns $100,000 annually. We have one child, a son, who is 14 years old. We also have $200,000 each in registered retirement savings plans (RRSPs), but no employer pensions nor other savings except for $25,000 in a chequing account for emergencies. We are considering borrowing money to invest. What are the pros and cons of doing this? We have no consumer debt, but still have a $150,000 mortgage at 2.5 per cent on our principal residence, which is worth about $1 million.” — Miguel
FP Answers: Borrowing to invest is a financial strategy that presents opportunities, but also pitfalls. It would be prudent to review your overall financial planning before choosing to implement a leveraged investment strategy since it can add a significant amount of risk to a financial plan and is not appropriate for all investors.
The most common leveraged investment for Canadians continues to be real estate. Most of us are comfortable taking out a mortgage to buy a home, but would shy away from borrowing money to invest in a securities portfolio.
The main reason why borrowing to invest in real estate is so much more common is that the underwriting process involved in buying a home is much different. There are credit checks, income confirmations and a home appraisal before any dollars are borrowed for a purchase.
Borrowing to purchase other investments, most typically a portfolio of stocks, mutual funds or exchange-traded funds (ETFs), is different. A home’s value is unlikely to significantly drop, although it can go down, but there are no restrictions on an investor putting their money into risky investments. Real estate is also less liquid. A stock or other publicly traded investment can be sold with a screen tap on a smartphone.
In most cases, you will have the ability to deduct interest payments that are related to the debt used for the investment. These will help lower your overall cost of investing. It bears mentioning that interest is only deductible if used to buy taxable non-registered investments. Borrowing to invest in RRSPs or tax-free savings accounts (TFSAs) does not allow you to deduct the interest on your debt.
Given your income and age, Miguel, I’m guessing you have RRSP room. You should probably max out your RRSPs before building a non-registered account. You both likely have $88,000 of TFSA room if you have never contributed, and that should be used before building a non-registered portfolio.
Let me outline the most common way a leveraged investing strategy would be set up. First, a source of funding is determined. In your case, since you own your home, it is most common to set up a secured home equity line of credit (HELOC), which could then be used to advance the funds to purchase the investments. Investors will use their home as security because it usually allows them to obtain better interest rates.
Once you have your borrowing source, then the reasonableness of the strategy should be reviewed. For most of the past 10 years, interest rates have been low. That has changed in the past year, and interest rates have significantly increased while the market has been low to flat after a volatile 2022. Given this development, borrowing to invest has become much less appealing.
The prime rate is often seen as a benchmark for borrowing rates across the retail banking sector and this has been in the range of five per cent to six per cent over the past six months, and could rise further. Given that rates are this high, the breakeven point on the expected investment return would have to exceed that amount to make the strategy reasonable. It’s no use borrowing to invest if you pay more in interest than what you could expect to earn on the investments.
Could you borrow at six per cent and get an investment return of eight per cent? Maybe. But is earning $2,000 per $100,000 of leverage life-changing? Probably not. You also have a $150,000 mortgage at 2.5 per cent that is going to come up for renewal at a much higher rate in the next couple of years.
If you do want to proceed with borrowing to invest, you need a high risk tolerance, low investment fees and a long time horizon to make it worth considering. At age 45, I suppose you have some runway to consider this. Just be careful and be mindful of some of the other considerations raised.
Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at email@example.com.