Borrowing money for investment purposes offers the ability to gain financial leverage. Leveraging when used prudently can dramatically magnify your goals, adding some muscle to your portfolio more quickly.
You are familiar with the concept of leveraging if you have ever:
- Borrowed to make a contribution to your RRSP
- Bought securities on margin from your broker
- Used a Line of Credit or term loan for investment purposes.
You could even say you use leverage when you take out a mortgage on your house because most people expect their residence to appreciate in value.
A better strategy for RRSPs is to make contributions on a regular basis throughout the year. It conveniently spreads out the deposits and offers the benefit of dollar cost averaging. If you find that you do need to take out an RRSP loan be sure to negotiate for the lowest interest rate possible, understand the terms and assumptions, pay off the loan as soon as you can and make sure you can afford the payments. Because of the nature of RRSPs, the interest on these loans is not tax deductible.
Brokerages offer margin accounts, which enable clients to borrow money against the equity in their portfolio for the purpose of making additional investments. It works like a secured line of credit. Clients are charged interest on the outstanding balance and can repay at any time without penalty.
However, under securities regulations, a brokerage can only lend you a set percentage of the total value of your investments. If the outstanding debt exceeds the maximum permissible loan amount, the broker is forced to make a margin call. Deposit more money or be forced to sell some or all of the investment, even at a loss, to make up the shortfall.
Being excessively leveraged in this way can rob you of control to effectively manage your portfolio. To avoid this, make certain you have plenty of excess capital. Set and keep to the strictest of limits on borrowing.
Short selling is borrowing shares of a company you don’t own in order to immediately sell these shares. To be profitable the shares must drop in value so you can then buy them at the lower price, repay your broker and pocket the difference.
The obvious risk is that the shares may increase in price. Margin requirements for short selling are generally much more strict.
Investment Loans or Lines of Credit
During bull markets it’s tempting to take out an investment loan. Clients make monthly payments of interest only. The reasoning is that the steady appreciation in the value of invested assets would repay the loan eventually through profits.
Losing money doesn’t alleviate the responsibility of having to pay the accumulated interest as well as, eventually, the principal.
The Smith Manoeuvre (thought up by Fraser Smith) is based on the idea of using a mortgage on your house to purchase investments, thus making the mortgage interest 100% tax deductible. Eventually the portfolio is sold to pay off the mortgage (after the tax on capital gains has been calculated). The idea is to pay off the loan much faster.
A modified Smith Manoeuvre uses an equity secured line of credit to purchase the investments. The benefit of this is most lines of credit only require a monthly interest payment. Weigh the costs involved to set up the loan e.g. appraisal and legal fees.
A lot of people are afraid to use this strategy because of the perceived risk of losing their home should the investments tank. However, if the interest payments can be easily made with your current cash flow the risk is less than using a margin account as you won’t be forced to sell your investments or your house should the market start free-falling.
Tax Deductible Interest
Apart from an RRSP loan (mentioned above), the full amount of interest paid on loans for investment purposes is tax deductible. There must be a reasonable expectation of appreciation in value.
If you sell leveraged investments at a loss and the proceeds are not enough to pay off the loan, the interest on the remaining balance is still a deductible carrying charge. You can continue to deduct the interest until the loan is fully repaid.
Consider the risks
If you consider leveraging to assist in building your wealth, keep your limits in mind. Always:
- Recognize that this strategy is not for everyone. There are multiple degrees of risk.
- Leveraging introduces additional volatility to portfolios.
- Borrow no more than you are prepared to lose.
- Realize the potential destructiveness of losing your whole portfolio of you fail to meet a margin call.
- Avoid being seduced by the allure of tremendously magnified profits because, unfortunately, it works the same way in the opposite direction, magnifying losses.
Do you think that borrowing to invest is a wise strategy?