Continued low-interest rates in Canada make the costs of borrowing very attractive, especially when purchasing assets that are likely to increase in value over time, such as a home. You may be tempted to take advantage of cheap interest, but is borrowing to invest a good idea?
The answer depends on many factors, including the type of investment, how long you plan to stay invested, and your ability to weather changing market conditions.
Here’s an overview of why you might consider borrowing to invest when it makes sense (and when you should think twice) about this strategy, and how to move forward if you decide it’s a smart decision for you.
Borrowing to Invest
While it might sound counterintuitive, there are many good reasons to take out a loan for the purposes of growing your nest egg. Here are just a few reasons why you might want to borrow to invest:
- To build your credit history. If you’ve never borrowed money, banks and other creditors have no way of knowing if you’re likely to make your payments on time. Without that knowledge, they may not offer you a very good interest rate when you want to take out a mortgage, car loan or line of credit. If, however, you borrow to invest in an RRSP, TFSA or non-registered account, and pay back that money in a responsible and timely manner, you are more likely to get a preferred rate of interest on your next loan.
- To maximize your returns. The longer you leave your money to grow, the better off you’ll be thanks to compounding returns. How so? Because you don’t just make money on the funds you invest, you also earn income on all your previous investment returns. When you combine the power of compounding with a proven low-fee investment strategy offered by a robo advisor like Wealthsimple or discount broker like Questrade, your savings can really snowball over time.
- To lower your tax burden. Since the government wants to encourage investment in Canadian companies and personal retirement savings, there are some attractive income tax benefits that come along with various types of investments, which we will explore in more detail below.
- To make investing a top-line expense. Some folks aren’t very disciplined about setting money aside for the future, and instead spend whatever income is left after paying the bills on discretionary expenses, such as entertainment or hobbies. For those people, it might be advantageous to borrow to invest so that the cost of the investment becomes a monthly non-discretionary “bill” in the form of a loan repayment.
Borrowing to Invest in Dividend Stocks
As mentioned above, there are tax-management tools that come along with some kinds of investments, including Canadian stocks that pay eligible dividends—so long as they are held outside of tax-sheltered accounts such as TFSAs or RRSPs.
If you borrow money to purchase non-registered Canadian dividend stocks, you can deduct all the interest charges on that loan from your annual taxable income. What this does, in effect, is make the cost of borrowing a little cheaper. When you compare the total cost of borrowing to the potential investment returns, you may find you’d come out ahead.
Here’s an example:
- Costs of borrowing: If you take out a $10,000 loan at a 5% interest rate for a three-year term, your monthly payment would be about $300 per month, and total interest paid over the three years would be about $790. But since you can deduct that interest from your taxable income, you’d save about $235 in taxes (assuming a marginal tax rate of 30%), making the total cost of the loan just $555. You can use a loan calculator to find out the specifics for your situation.
- Investment returns: Let’s say you decided to purchase low-fee Canadian dividend exchange traded funds (ETFs) through one of Canada’s leading robo advisors or discount brokerages in Canada, and earned an annual average return of 4% (of which 2% was paid out in dividends) over those three years. Your $10,000 investment would be worth nearly $11,250 at the end of the three-year period, meaning you came out ahead by $695 ($1,250 investment gain – $555 cost of borrowing = $695).
- Taxes: Dividends from investments held in a non-registered account must be declared as income on your annual tax return. But you can also claim a dividend tax credit, which lowers your tax hit. In our example, since 2% ($625) was paid in dividends, the amount of income tax you’d have to pay would be well under $187.50 (assuming a 30% marginal tax rate). The other 2% in investment earnings is called a capital gain and is only taxable in the year you sell the investment, and then only at 50% of your marginal rate.
- Final Tally: Even after taxes paid on the dividend income, you would come out more than $500 ahead by borrowing to invest under these conditions. More importantly, if you held on to your investment and averaged the same modest 4% annual return, your nest egg would quadruple in value (to nearly $40,000) in 30 years time.
An important caveat: there’s no guarantee that the value of your investment will grow over the three-year period—it could actually lose ground—and/or the size of the dividend payments could be less than expected. However, if you plan to invest for the long haul, and have the stomach to stay invested even when markets are down, you will enjoy solid returns since markets typically outpace inflation over the long-term.
Leveraging Home Equity Line of Credit (HELOC) to Invest
Using funds from a home equity line of credit to invest in dividend stocks would be similar to the scenario above, but with a few major differences.
- You’d likely have access to a significantly larger sum of money (and a better rate of interest) since the funds are secured by the equity in your home. Of course, that also increases your risk since your home could be at stake if you’re unable to make the interest payments.
- If you aren’t disciplined about paying back the money you withdraw from your HELOC, you could end up paying more in total interest over time, even if your rate is low.
- By the same token, your tax deductions for the interest charges could be sizable, and they might even lower your taxable income enough to qualify for an increase in income-tested benefits, such as the Canada Child Benefit or Old Age Security.
- Borrowing and investing a larger sum of money might make it psychologically harder for you to stay invested if there’s a market downturn. For example, a 20% annual market loss on a $10,000 investment is $2,000, but the same percentage loss on a $100,000 investment is $20,000. And that loss may feel even more acute when you add the fact that your investment may be worth less than the outstanding debt on your HELOC.
To recap, leveraging your HELOC to invest could be a smart strategy if you:
- Have a lot to gain through the interest tax deductions;
- Are certain you’ll be able to make your interest payments with ease and have a plan to pay back the principal;
- Plan to invest for at least 10 years and will stay in the market even if you experience sizable annual losses.
Should I Borrow to Invest in an RRSP?
Another way borrowing to invest can give you a tax advantage is by taking out an RRSP loan. Many people do this to use all their allowable RRSP contribution room, which they can then deduct from their taxable income in the year they make the contributions.
Using our earlier example of a $10,000 loan at a 5% interest rate for a three-year term, and average annual investment returns of 4%, here’s the math on an RRSP loan:
- Costs of borrowing: About $790 in interest over three years. That amount would be offset, however, by the income tax deduction for making a $10,000 RRSP contribution. If your marginal tax rate is 30%, that’s a tax savings of $3,000, which more than covers your interest payments.
- Investment returns: About $1,250 over three years, as explained above.
- Taxes- $0 during the three-year period (as long as you stay invested) since all income earned inside an RRSP is tax free. When you withdraw the funds however, you are taxed at your marginal tax rate.
- Final tally: At the end of the term, you’re ahead by nearly $3,500. ($3,000 in tax savings – $790 loan interest charges + $1,250 investment returns = $3,460). But this is the case only if you keep the money in your RRSP. If you choose to withdraw your RRSP investment (worth nearly $11,250) at the end of the three-year period, you’ll get taxed at your marginal rate. Assuming it’s still 30% (it might even be higher if you got a raise and moved into a higher tax bracket) that would be a tax hit of $3,375, bringing your final tally down to a measly $85 or less in our example.
Borrowing to Invest in TFSA
If you choose to take out a loan to invest in a TFSA, you can’t write off the interest payments from your taxes as you would with dividends in non-registered accounts, and you don’t get a tax deduction for your contributions, as you would with an RRSP. (For more information on the differences between these two popular registered accounts, check out Young and Thrifty’s TFSA vs. RRSP comparison.)
That means you need to weigh the full cost of the loan against the potential tax-free gains on your investment.
Here’s how the numbers add up for a TFSA loan, using the same parameters as above:
- Costs of borrowing – About $790 in interest over three years.
- Investment returns – About $1,250 over three years.
- Taxes – $0, since all earnings in a TFSA are tax-free
- Final tally – You’d still come out ahead by more than $400 in this scenario ($1,250 – $790 = $460). Plus, even if you choose to sell your investments and withdraw the funds immediately at the end of the three-year period, you wouldn’t have to pay any tax or penalties, as stipulated by the TFSA rules.
When to Avoid Borrowing for Investments
Even if you’ve crunched the numbers and think you can come out ahead by borrowing to invest, there are some situations when it’s probably not a good idea, such as:
- If you’re in a very low tax bracket since the tax savings would be minimal.
- If you already have a lot of debt, since you may end up defaulting on your payments which can ruin your credit rating.
- If you have precarious employment, which means you might not have enough income in the future to afford the loan payments for the full term.
- If you’re prone to rash decision making when markets plummet, since selling low will wipe out any potential benefits of borrowing to invest.
Borrowing to invest can be a good idea, depending on your financial circumstances. Before taking the plunge, thoroughly review of your finances, weigh the pros and cons of all options, and above all, do the math. If you’re willing to invest for the long-run, borrowing to invest could be a savvy strategy for building your nest egg.
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