While interest rates remain near historic lows, borrowing money to invest continues to look like an attractive investment strategy.
We believe that this strategy works best if you borrow to buy well-established, dividend-paying stocks. For instance, you could select from the companies we recommend in the 2016 Income-Seeking Investors Portfolio of The Successful Investor newsletter.
Investing advice: Borrowing to invest can trigger significant tax advantages
We’re in the middle of a tumultuous 2016, but loan interest rates haven’t changed much in the last three years: you can borrow for as little as 3.2% if you use your home as collateral, for example. Over long periods, the total return on a well-diversified stock portfolio runs to as much as 10%, or around 7.5% after inflation. So you can expect to earn more than your borrowing cost.
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Borrowing to invest can also be a highly effective tax shelter. You can deduct 100% of your interest expense against your current income. What’s more, the investment income you earn brings three key tax advantages: you get the dividend tax credit on qualified Canadian stocks and you only pay income tax on 50% of your capital gains.
In addition, you are only liable for capital gains when you sell; if you buy high-quality investments, 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.
Investing advice: 6 keys to make the most of borrowing to invest
As appealing as low rates and the undoubted tax advantages of this strategy are, borrowing to invest does entail risks. The amount you owe on your investment loan will stay the same, regardless of what the market does, so every dollar your portfolio 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.
COMMENTS PLEASE
Have you ever borrowed to invest? How did it work out for you? Would you do it again? Click here
That’s why we invariably advise that you only consider borrowing to invest if all six of the following apply to you:
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 investing advice and stick with quality investments;
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 and TFSA contributions.
So Pat, you would never borrow to invest in your RRSP? I would think most people would not be even close to maxxed out and borrowing would be a great way to do that.
why would you only do it after maxxing out RRSP and TFSA ?
If you could buy on margin when the market hits bottom, stay margined as the market rises, and sell out at the peak, you could very quickly acquire a measurable proportion of all the money in the world. Nobody ever succeeds in that, of course. This gives you an indication of the difficulty of spotting and profiting from market tops and bottoms, with or without the use of margin.
My view is that if you are going to use margin borrowing to invest, it’s all the more important to follow our three key investing rules: invest mainly in well-established companies; spread your money out across the five main economic sectors; and avoid stocks that are in the broker/media limelight. If you religiously follow that advice and expand your portfolio using margin, you are going to make money over long periods — and you will gain tax benefits.
You’ll be able to write off your margin interest in full against ordinary income in the current year. However, you’ll pay less than ordinary income-tax rates on dividends from Canadian stocks, thanks to the dividend tax credit. More important, you’ll defer all capital gains taxes until you sell, and only pay taxes on capital gains at half the rate you pay on ordinary income.
If you invest on margin in years when you are in a high tax bracket, and take capital gains into income in years when you are in a low tax bracket, so much the better.
I do think the market will continue to rise during the rest of 2009, and using margin this year is likely to increase your profits. However, I know, and you should also be aware, that I can be wrong about the market’s future direction. So can anybody else.
You also need to keep in mind that margin investing expands your leverage, and leverage works two ways: It magnifies your profits when the market moves in your favour, but it magnifies your losses just as effectively when the market moves against you.
So, to sum up, I’d say investing on margin can be a great tax shelter and investment technique if:
1) you are in the top tax bracket and expect that you’ll remain in it for the foreseeable future;
2) you follow our conservative three-part investing approach;
3) you invest consistently over a number of years, and resist the temptation to increase your margin borrowing when stocks have risen, or reduce it when prices have dropped.
I advise against investing on margin unless you qualify under all three conditions. This rules out a lot of margin investing in retirement.
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So Pat, you would never borrow to invest in your RRSP? I would think most people would not be even close to maxxed out and borrowing would be a great way to do that.
why would you only do it after maxxing out RRSP and TFSA ?
Thanks!
If you could buy on margin when the market hits bottom, stay margined as the market rises, and sell out at the peak, you could very quickly acquire a measurable proportion of all the money in the world. Nobody ever succeeds in that, of course. This gives you an indication of the difficulty of spotting and profiting from market tops and bottoms, with or without the use of margin.
My view is that if you are going to use margin borrowing to invest, it’s all the more important to follow our three key investing rules: invest mainly in well-established companies; spread your money out across the five main economic sectors; and avoid stocks that are in the broker/media limelight. If you religiously follow that advice and expand your portfolio using margin, you are going to make money over long periods — and you will gain tax benefits.
You’ll be able to write off your margin interest in full against ordinary income in the current year. However, you’ll pay less than ordinary income-tax rates on dividends from Canadian stocks, thanks to the dividend tax credit. More important, you’ll defer all capital gains taxes until you sell, and only pay taxes on capital gains at half the rate you pay on ordinary income.
If you invest on margin in years when you are in a high tax bracket, and take capital gains into income in years when you are in a low tax bracket, so much the better.
I do think the market will continue to rise during the rest of 2009, and using margin this year is likely to increase your profits. However, I know, and you should also be aware, that I can be wrong about the market’s future direction. So can anybody else.
You also need to keep in mind that margin investing expands your leverage, and leverage works two ways: It magnifies your profits when the market moves in your favour, but it magnifies your losses just as effectively when the market moves against you.
So, to sum up, I’d say investing on margin can be a great tax shelter and investment technique if:
1) you are in the top tax bracket and expect that you’ll remain in it for the foreseeable future;
2) you follow our conservative three-part investing approach;
3) you invest consistently over a number of years, and resist the temptation to increase your margin borrowing when stocks have risen, or reduce it when prices have dropped.
I advise against investing on margin unless you qualify under all three conditions. This rules out a lot of margin investing in retirement.