Weigh the risks and benefits before borrowing to invest

Canadians borrow money every day to buy homes, cars, boats, and a whole host of durable goods. In most cases, we borrow money to buy consumer goods that may not be financially productive. However, we justify these purchases because they satisfy our day-to-day needs.

Far fewer Canadians have explored the concept of borrowing money to invest — an exciting but scary proposition. Borrowing to invest, or using “leverage,” can create numerous benefits but it can also create risks. Let’s review some of the pros and cons to determine if this financial planning strategy makes sense for you.

The benefits

There are five key benefits generated by borrowing money to invest in various tax-efficient investment vehicles:

You can build your wealth using other people’s money. This is similar to buying a home, where the mortgage provided by the bank allows you to purchase the house with the bank’s money.
As a result of the additional funds borrowed, you may able to diversify your investment portfolio holdings further.
Given the fact that you now have a monthly loan payment, in essence you have created a forced savings plan. This is especially helpful for investors who have found it challenging in the past to stay the course on monthly savings plans.
Borrowing money to invest may create a deduction for interest costs incurred. However, it is always best to consult a professional advisor for any tax or legal advice.
Leverage can magnify your effective after-tax returns.

As you can see, the potential benefits are exciting. Now, let’s look at the down side.

The risks

Balancing the five key benefits are five key risks:

Magnified losses. Just as leveraged investing can magnify your effective after-tax return, it can also magnify your losses. Leveraging does not remove inherent risks in the market or prevent you from making bad investment decisions.

Interest rate risk. If interest rates rise, you will need a sufficient cash flow cushion to accommodate the increased cost of a floating rate loan or line of credit.

Changing legislation. The tax rules regarding the tax deductibility of interest are subject to revision. It’s important to keep abreast of changes.

Margin calls. Remember, a loan is a legal obligation that must be paid back, regardless of how the investments perform. If their value goes down, you may be subject to a margin call, depending on the type of investment loan used.

Emotional risk. In times of rising markets, this risk may be minimal. When markets decline, however, you may find your emotions running high.

Is it for you?

Borrowing to invest is essentially suited for investors who:

have excess income or cash flow after removing current/future debt obligations
need to consider alternative tax strategies
have a higher-than-average risk tolerance
are thinking long-term (that is, a time horizon of 10 to 20 years)
have no Cumulative Net Investment Losses

Consult your Investment Planning Counsel Financial Consultant for more information regarding leverage loans and to see if these or other strategies make sense within your financial plan.