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Learning Centre

Borrowing to Invest - The Good, The Bad and The Ugly

By: Heather Nageleisen CFP

People borrow money every day to buy homes, cars and other items. However, far fewer people use borrowed money to invest.

The continuing low interest rate environment keeps the strategy of borrowing to invest, or leveraging, in the spotlight. However, emotions often lead investors to see only the pot of gold at the end of the rainbow without considering the potential rollercoaster ride along the way caused by market downturns and interest rate hikes.

Borrowing to invest is certainly not for everyone; it involves being able to stick to a plan and keep emotions out of investment decisions. In general, it is a strategy suited for investors who have excess cash flow after debt obligations are covered, have a need to consider alternative tax strategies, have a higher-than-average risk tolerance and have a long-term investment horizon (10 + years).

This strategy can have numerous benefits but there are also accompanying risks. Here's a look at issues investors should consider before borrowing to invest.

The Good

Investing in good quality assets with borrowed money can have some exciting benefits.

• Building wealth. Borrowing to invest in assets that grow in value can improve one's net worth substantially. This is similar to buying a home, where money (a mortgage) from a bank allows you to purchase a house. The expectation is that the investment will grow and be worth more when it comes time to sell it.
• Diversified portfolio. Borrowing additional money to invest provides the means to build a more diversified portfolio.
• Tax savings. Borrowing money to invest may create a tax deduction for the interest costs paid on an investment loan.
• Forced savings. A monthly loan payment is, in essence, a forced savings plan. This may be helpful for investors who have found it challenging to stay the course on monthly savings plans.
• Magnified returns. After considering the tax implications of deductible loan interest, bottom line investment results can be more favourable.

The Bad

Unfortunately, the downside of a leverage strategy seems often to go unheeded in the face of tax savings and exponential investment portfolio growth. Some of the risks associated with leveraging are:

• Magnified losses. Just as leveraged investing can magnify effective after-tax return, it can also magnify losses. Leveraging does not remove the risks associated with the market or prevent poor or unsuitable investment decisions.
• Interest rate risk. If interest rates rise, a sufficient cash flow cushion is required to accommodate the increased cost of a floating rate loan or line of credit.
• Interest deductibility. The tax rules regarding the tax deductibility of interest are complex and subject to revision. It's important to keep informed of changes and maintain clear records.
• Margin calls. A loan is a legal obligation that must be repaid, regardless of how the investments perform. If their value goes down, a margin call, or requirement to provide additional collateral may occur, depending on the type of investment loan used.
• Emotional risk. When markets decline investors quickly learn how intertwined money and emotions really are.

The Ugly

This brings us to the worst potential scenario - the cost of borrowing climbs while investment values drop. Not only will this situation wreak havoc on investor nerves, but if panic sets in and investments are sold at a loss it leaves the investor to cover the difference between the outstanding loan and the investment proceeds out of their own pocket. And what if the cash isn't available and the loan has been secured by using a home as collateral? Now that's ugly. This is one of the primary reasons that many who leverage never realize a net benefit - they don't have the ability, whether it be emotional or monetary, to stick to a long-term leverage plan.

It is important to understand the complete impact that a leverage strategy could have on one's life and not simply the financial aspect. There is much more to consider than reaching that 'pot of gold.' Individuals should consult with trusted professionals, including a Certified Financial Planner professional before considering borrowing to invest.