Borrowing To Invest

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.

RRSP loans

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.

Margin Trading 

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

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.

Smith Manoeuvre

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?

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  1. KenFaulkenberry on March 6, 2012 at 7:28 am

    The “Consider the Risks” section is SO important with this subject. There are very few circumstances where people should be borrowing to invest. Building wealth is hard enough without taking unnecessary risk (leverge) that can set your goals back by years or even decades.

    • Boomer on March 6, 2012 at 3:15 pm

      @KenFaulkenberry: It’s so easy to be drawn in to leveraging when interest rates are low and the market is booming and some salesperson is touting how much your investments will increase. But they need to be aware of the downside too. This is why people committed suicide back in the 1929 crash when they lost everything, and one of the reasons why Lehmann Bros went bankrupt more recently.
      Knowing your limits and actual risk tolerance is crucial before proceeding.

  2. Marianne on March 6, 2012 at 8:03 am

    With our Manulife1 Account, the Smith Manoeuvre is very tempting but the risk is a bit scary to me. I may do a bit of a modified approach- not quite all-in. The other risk that concerns me on this one is if interest rates start climbing and the interest payments suddenly skyrocket and are no longer easy to pay for…

    • Boomer on March 6, 2012 at 3:18 pm

      @Marianne: You need to be sure that you are comfortable making the interest payments especially when what often happens is the interest rates go up when the stock market goes down.

  3. krantcents on March 6, 2012 at 10:49 am

    Borrowing to invest is very risky and should be handled very carefully. If you speculate, you lose twice, your investment goes down and you added to your debt.

  4. Ellen on March 6, 2012 at 2:31 pm

    You need to know what you’re doing. I know someone who borrowed to invest and bought Yellow Media. He’s not a happy camper right now.

    • Boomer on March 6, 2012 at 3:20 pm

      @krantcents: This strategy is certainly not for everyone – or even for most investors. You have to know what you’re doing, be really on top of what’s going on and have a reasonably high tolerance for risk.

  5. Jeremy @ Modest Money on March 6, 2012 at 2:49 pm

    Like others I would probably avoid these strategies because of the risk involved. I did get an RRSP loan a couple years back. I was faced with a big tax bill from my side business income. So at the time it seemed to make sense to get a bunch of RRSPs before the deadline to bring down my tax bill. Now I just do regular contributions throughout the year to avoid the hassle and potential interest.

    • Boomer on March 6, 2012 at 3:21 pm

      @Jeremy: For RRSPs regular contributions make the most sense.

  6. SE Book on March 6, 2012 at 9:03 pm

    I don’t think it is ever a good idea to take others money and invest it. You never truly know how one thing or another is going to pan out, so best not to gamble with others money.

  7. Ed Rempel on March 7, 2012 at 5:52 pm

    Hi Boomer,

    Your description of the Smith Manoeuvre is not correct. You don’t actually use your mortgage to invest. The strategy converts your mortgage into a tax deductible credit line over time.

    It is a strategy to invest for your retirement without using your cash flow. It is an option for people who are unable or unwilling to invest enough to be able to have the retirement they want. If they will be short, they could also use the equity in their home to invest for the long term, which can make up the shortfall in their retirement plan.

    The Smith Manoeuvre involves getting a readvanceable mortgage, which is a mortgage linked to a credit line. As your mortgage is reduce by your regular payments, you gain credit available in the credit line linked to it. You can borrow that amount and invest it.

    Over time, your mortgage is paid off and you borrow up to 80% of your home value to invest from the credit line.

    You can also “capitalize” your interest, so that the entire strategy takes none of your cash flow until after your mortgage is paid off.

    After your mortgage is paid off, you can either sell investments to pay off the credit line or you can decide to keep the credit line for life. The most effective strategy can be to keep your tax deductible credit line for life and always just make the payment right through your retirement. This means you can maintain your investments, which can make a big difference in your retirement income.

    Your are right that borrowing to invest is quite risky. The best way to deal with that risk is to make it a long term strategy. The stock market can be very volatile and unpredictable, but it actually quite reliably makes a good return over the long term.

    For example, the worst ever 25-year period for the S&P500 in the late 150 years was a gain of 5%/year, which would almost quadruple your money. In the last 60 years, every 25-year period was a gain of 8%/year or more.

    It is very risky to try it short term, but if you borrow to buy high quality, diversified stock market investments for 20-30 years or more and don’t make the market timing errors that most investors do, then it can be a very effective strategy for helping you have the retirement you want.


    • Boomer on March 7, 2012 at 8:17 pm

      @Ed Rempel: Thanks for the clarification Ed. I know that is uses a combination mortgage and secured credit line and the amount of the mortgage payment that is applied to the principal becomes available to you to invest through the line of credit. I probably did not explain it clearly enough (It made sense in my head).

  8. Adam on March 7, 2012 at 5:55 pm

    Sensible advice! As someone who is wary about investing AND borrowing, it’s a lot easier to try and avoid the subject altogether. The breakdown of which loans do what and the risk factor assigned helps me understand the concept a little better and who knows… maybe I’ll be more likely to invest knowing that I can borrow.

  9. My University Money on March 10, 2012 at 12:16 am

    It always amazes that some forms of leverage are very socially acceptable while others are not. Borrowing money to get a Bachelor of Arts degree is a great investment according to most people (debatable), yet borrowing to invest is not. People are radically afraid of the SM, but will own several rental properties with large mortgages because, “You actually have a physical asset behind your money, not like in the stock market.” I plan on having some leverage in my portfolio for at least the next 15-20 years and will sleep soundly because of basic math truths (as Ed has mostly detailed above).

  10. Money Manifesto on March 10, 2012 at 10:06 am

    I for one would rather borrow to accumulate or add to an appreciating asset, than a depreciating asset.

    Loans to purchase a house, make home improvements, or purchase investments make far more sense than car loans, furniture loans, or financed trips to the mall.

    Done correctly, and by picking the right asset, most of the risk can be removed when borrowing for investment purposes. There are investment products on the market that allow the investment value to be locked in. If the investment goes below this amount, you are still guaranteed to receive the locked in amount should you sell. If you are leveraging the equity in your home for an investment (via the Smith Manoeuvre or modified Smith Manoeuvre) then I would suggest using this kind of product.

    The main stream thinking is that debt is a bad thing. This is not necessarily true. The wrong kind of debt is bad. Using debt to purchase assets that will appreciate over time is good and a proper way to use debt effectively.


  11. fastneasytax on March 10, 2012 at 8:36 pm

    This is how I have used borrowing to invest –

    1. First converted general mortgage to Home Equity Line of credit with 2 portions – mortgage portion and remaining portion available for investment . This gets me a very favourable rate for investment loan – prime rate.
    2. Find a fee based financial advisor and invest in F-series funds – F series funds have lower MER and difference in MER will cover the fee. So, you get the service of a fee based advisor with no additional cost.
    3. Last year, I had a investment income of around $4k even after all the market turmoil. After deducting the interest expense and advisor fee (yes, that is deductible), I will have a gain of 2k.

    Plan it wise and you will eventually make money.

  12. Paula @ Afford Anything on March 12, 2012 at 10:58 am

    My strategy is to leverage into cash-flow-positive rental properties. I borrow money, but the income from the rental pays all my monthly expenses plus some extra for padding/emergencies. Over time, I build equity in the property and reduce my leverage/risk, without contributing much of my own cash.

  13. Ed Rempel on May 20, 2014 at 11:10 pm

    Hi Fastneasytax.

    Your idea of using a fee-based financial planner may work for you, but we have found we use it a lot less than you may think.

    We use either commission-based, fee-based or “institutional pricing”, whichever is best for each client. Fee-based is actually the one we use the least.

    A fee-based financial planner generally charges about 1% of your investments plus HST, so the total fee is about 1.135%. In general, F class mutual funds have an MER about 1.135% lower than the regular A class funds. In total, your fees are generally about the same.

    The difference is that your fee is fully tax deductible each year, rather than just reducing your future capital gain.

    There are some downsides, however. There is usually an annual fee for each fee-for-service account, generally about $200/year/account. And each monthly fee is paid by selling units of your funds, which will trigger capital gains.

    Overall, you may well still ahead, depending on the size of your account and your tax bracket. There is more work involved in tracking and recording the transactions, so you probably wouldn’t want to bother if you only save a small amount.

    In general, commission-based costs you the least if your account is not that large. Depending on your tax bracket and number of accounts, going fee-based can save you some money when your account gets larger, however once you can qualify for the “institutional pricing” funds, you save money be switching out of fee-based.

    Institutional pricing funds have lower fees (usually about .2% to .3%/year lower) and you can avoid the annual account fees typical of fee-based accounts.

    Institutional pricing funds go by a variety of names, such as class E, and you generally need $100,000/fund/account to qualify for them.

    I hope this is helpful for you, Fastneasytax.


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