Topic: Dividend Stocks

Pros and Cons of Borrowing to Invest in Dividend Stocks

borrowing money to invest in the stock market

Borrowing to invest in dividend stocks may be a good decision if you meet these six criteria

Borrowing to invest can make sense for some investors under certain circumstances. We think you’ll benefit most from this buying opportunity by sticking with high-quality stocks, especially Canadian dividend stocks. That suggest borrowing money to invest in the stock market works best when you focus on dividend-paying stocks, which give you regular dividend income and provide cash flow to pay the interest on your investment loan.

Borrow money to invest and you could benefit in these three ways:

  • Low interest rates favour borrowing to invest: When borrowing money to invest in the stock market, having low interest rates available to you is one of the best signs that it will make financial sense. Over long periods, the total annual return on a well-diversified portfolio of high-quality stock market investments, such as Canadian dividend stocks, runs to as much 7.5% after inflation.
  • You can use your dividends to pay your investment loan interest: If you borrowing money to invest in the stock market, buying well-established, dividend-paying stocks, like the Canadian dividend stocks we recommend in our Successful Investor newsletter, should 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 in Canadian dividend stocks can be a highly effective tax shelter. That’s because you can deduct 100% of your interest expense against your current income.

Borrowing to invest in dividend stocks can pay off—but it’s not without risks

As we indicated, over long periods, the total return on a well-diversified portfolio of high-quality stocks runs as much as 7.5% after inflation. So, in addition to the tax advantages, you can expect to earn more than your borrowing cost.

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But borrowing money to invest in the stock market 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 your portfolio gains or loses 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 your stocks.

On the other hand, borrowing to invest can be a highly effective tax shelter. As mentioned, you deduct your interest expense against your current income. But 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 like Canadian dividend stocks, you’ll wind up holding some of them for as long as you live. It’s a great tax-deferral technique. And it’s perfectly legal.

Still, borrowing to invest in dividend stocks 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 borrowing money to invest in the stock market can pay off;
  • 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;
  • You have already made your maximum RRSP contributions.

Bonus tip #1: Invest in dividend stocks to maximize your long-term portfolio returns

Some good companies reinvest profits instead of paying dividends. But fraudulent and failing companies hardly ever pay dividends. So if you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks.

We focus on dividend stocks that have industry prominence, if not dominance. Our reasoning, besides brand recognition, is that major companies can influence legislation, industry trends, etc. to suit themselves. Minor firms can’t do that.

If you stick with top-quality high dividend yield stocks, the income you earn can supply a significant percentage of your total return—as much as a third of your gains.

Dividend stocks are an important contributor to your long-term gains, and dividend-paying stocks tend to expose you to less risk than non-dividend-payers. That’s why the majority of your stocks should be dividend-payers at all times. As you get older and closer to retirement, you should raise the proportion of dividend-paying stocks in your portfolio, to cut risk and improve the stability of your investment results.

Bonus tip #2: Use our three-part Successful Investor approach to make better stock selections. That’s key when borrowing money to invest in the stock market

  1. Hold mostly high-quality, dividend-paying stocks.
  2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
  3. Downplay or stay out of stocks in the broker/media limelight.

In summary, this article discusses the benefits and risks of borrowing money to invest in the stock market, particularly in Canadian dividend stocks. The key advantages include the potential for higher returns than borrowing costs, using dividend income to pay loan interest, and tax benefits such as deducting interest expenses and the dividend tax credit. However, risks include increased leverage and potential interest rate increases. The article recommends this strategy for investors in the top tax bracket with secure income, a long-term horizon, a low-risk approach, and the temperament to weather market setbacks. It also suggests investing in high-quality, dividend-paying stocks across various economic sectors and avoiding overhyped stocks. The article emphasizes the importance of dividends in providing steady income and reducing risk, especially as investors approach retirement. Overall, borrowing to invest in Canadian dividend stocks can be a viable strategy for certain investors, but it is crucial to carefully consider individual circumstances and risk tolerance before proceeding.

Warren Buffett has referred to leverage as addictive. What are your thoughts?

What is your opinion on borrowing to invest in the stock market? Do you think it’s worth the risk under the right conditions?

This article was originally published in October 2010 and is regularly updated.

Comments

  • John C 

    Re. Pros and cons of borrowing to invest. I meet 3 of your 6 requirements. I am a regular user of margin loans. I am 10 years retired, do not have an RSP, and tax brackets are a myth. Taxes are levied on a sliding scale. My rule for using margin is that it must not exceed 6 months of dividend income. You might ask “what if dividends are cut?” It simply means that it will take 7 months to pay off. I assume that you are in favor of DRIPing. I call my strategy DRIPing in advance. I have control of dividend income allocation. Also, I avoid the bother of keeping track of the adjusted cost base.

  • Robert 

    I felt that borrowing to invest might be a great idea until I read the 6 questions to ask myself and found that I answered NO to the first 3. I still might look at this while interest rates are still low, however I am not looking at my portfolio every day. Usually a detailed look once a month and a rebalancing every 6 months if needed. So perhaps I should leave well enough alone, relax, enjoy reinvesting dividends, and life as it is.
    Robert

  • Bill 

    Many great lines have been written about “taking action when the time is right”. The “leverage strategy” can also work with high quality mutual funds or ETFs. Back in 2009 when I saw dividends on good Canadian stocks around 5 or 6 % and higher , I jumped in and bought a couple bank stocks, BCE and one or two others, all dividend payers; I have since significantly reduced the debt, even though the interest paid is tax-deductible. This strategy works but mostly you have to be “bottom feeders” and gobble up mostly good stocks. Timing IS important. Success favours the bold when the clouds are darkest !!

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