There are reasons for and against borrowing to invest, but the primary benefit is that it’s a perfectly legal tax shelter.
Borrowing to invest can be a highly effective tax shelter. You deduct your interest expense against your current income. And at the same time, the investment income you earn comes with three key tax advantages: you get the dividend tax credit on qualified Canadian stocks and you only pay income tax on half of your capital gains. In addition, you are only liable for capital gains when you sell; if you buy high-quality investments, you may wind up holding some of them for as long as you live. It’s a great tax-deferral technique. And it’s perfectly legal.
Three ways to benefit from borrowing to invest
Low interest rates favour borrowing to invest: Having low interest rates available to you is one of the best signs that borrowing to invest will make financial sense. Over long periods, the total return on a well-diversified portfolio of high-quality stock market investments runs to as much as 10%, or around 7.5% after inflation. So you can expect to earn way more than your borrowing cost.
You can use your dividends to pay your investment loan interest: If you borrow to buy well-established, dividend-paying stocks (or ETFs that invest in these stocks), like those we recommend in our Canadian Wealth Advisor newsletter, these investments will give you regular dividend income and cash flow to pay the interest on your investment loan.
Borrowing to invest can cut your tax bill: Borrowing to invest can be a highly effective tax shelter. That’s because you can deduct 100% of your interest expense against your current income. Plus, as mentioned, the investment income you earn comes with three key tax advantages: you get the dividend tax credit on qualified Canadian stocks and you only pay tax on 50% of your capital gains.
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Six ways to tell if borrowing to invest is right for you
Borrowing to invest only makes sense if all six of the following apply:
You are in the top income-tax bracket and expect to stay there for a number of years;
Your income is secure;
You have 10 or more years until retirement;
You follow our low-risk investment approach;
You have the kind of temperament to sit through the inevitable market setbacks without losing confidence at a market bottom and selling out to repay your loan;
Borrowing to invest is not without risks, including the risk of increasing your leverage. The amount you owe on your investment loan will stay the same, regardless of what the market does, but every dollar of your portfolio gains or losses will come out of your equity. In addition, if you take out a variable rate loan, the interest rate you pay could eventually rise above the return on the fund.
No benefit to connecting a borrowing to invest strategy with RRSP withdrawals
We feel most investors should make their maximum RRSP contributions before borrowing to invest. You’ll get a tax deduction for your RRSP contribution, and RRSPs shield all of your investment income from tax, not just capital gains.
Of course, borrowing to invest can go wrong if you buy at the top of the market and sell at a low. However, taking out an investment loan can be a good investment strategy for certain investors.
As detailed above, you may consider borrowing to invest if you are in the top income tax bracket and expect to stay there for a number of years, you have 10 or more years until retirement, and you have the kind of temperament to sit through the inevitable market setbacks without losing confidence at a market bottom and selling out to repay your loan.
Have you ever employed a borrowing to invest strategy? How did it work for you? Share your experience with us in the comments.
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