Pattie's Blog: When should you borrow money to invest?
A trader reacts as the German stock index DAX rises at the stock market in Frankfurt, central Germany, Thursday, Aug.11, 2011. (AP / Michael Probst)
Published Monday, July 30, 2012 8:00AM EDT
Last Updated Wednesday, August 1, 2012 7:11AM EDT
I was out for a walk the other day when a gentleman approached me and after saying "hello" got straight to the point -- should he borrow money to get into these markets given his long-term perspective and what he perceives as a great buying opportunity?
I typically get this sort of question during strong bull markets, which tends to encourage investors to capitalize on the upswing. In this type of market however, many investors want to reduce their appetite for risk and borrow less. And this is what makes a market -- you have buyers and sellers and both think they are right. However, borrowing to be a buyer has an additional layer of risk and yet greater upside potential.
Ask yourself: Is borrowing to invest the right move for me?
Borrowing to invest can make sense, but you need to understand the risks involved. You should ask yourself if going into debt -- borrowing money to invest -- is part of your investment strategy. Is it suitable for your financial personality? Borrowing to invest does have a tax advantage. As a general rule, interest costs can be applied to reducing the tax bill to the extent there is a reasonable expectation of profit from the investment. It is important to note that RRSP and TFSA loans do not qualify to have interest deducted from taxes.
When you borrow money to purchase securities it involves greater volatility and risk than using only cash because borrowing magnifies the gains and losses. I'll give you an example…
If you invest $5,000 in a stock that costs $50 you could buy 100 shares. If you had used 50 per cent margin (borrowed), you could have invested $10,000, so the same $5,000 investment could now purchase 200 shares instead of the 100 shares. If the stock price when up to $75 the gain would be $5,000 as opposed to $2,500 had you not borrow the money to invest. Sounds very appealing. Here is the downside risk -- if the stock went from $50 to $25 the loss would be $5,000 as opposed to $2,500 had you not borrowed.
Also, you should have the cash flow to pay down at least the monthly interest expense, to avoid compounding interest costs.
Ways you can borrow to invest:
- A line of credit can be secured or unsecured. Borrowing from a secured line of credit will carry a lower interest rate. Security can be in the form of a house, stock or bond. Just remember if your investment goes down not only are you losing money on the investment but the loan also has to be repaid. I have seen people borrow against their home to invest in the market and lose not only their investment but also their home. Proceed with caution.
- Borrowing from a brokerage house is called margin. The expectations would be that the value of a stock will go up. Depending on the price of the stock and their volatility, margin rates will be different.
My response to the gentleman:
Before you decide to borrow to invest, research the stock thoroughly and have a very clear understanding of your cash flow. Know the margin rules and the firm's policies and very carefully read the margin agreement and the disclosure statement. Given the higher risk, you must actively monitor your investments. You can't borrow to invest and then be lax. Remember to factor the interest costs into your decision making. There is no margin (excuse the pun) for error. Borrow prudently and keep some cash on hand to meet a margin call should your investments perform badly.
Bottom line -- investing using borrowed money is not for everyone and if I'm honest it has never been for me. However, I recognize it is a legitimate investment strategy and one that many employ. I just want to ensure that before you proceed you make sure it fits with your overall financial strategy and be very sure you know exactly what you are getting yourself into.