Borrowing to invest could increase both return potential and risk.
Many Canadians already borrow to invest without thinking about it that way. Taking out a mortgage to buy a home is, technically, leveraged investing. The homeowner borrows part of the money needed to make an investment in real estate that he or she couldn’t otherwise afford. As a result, the homeowner is more exposed to fluctuations in the real estate market – benefiting more if the market value of the home rises but also risking more if the market value of the home falls.
Some people choose to use a similar strategy when investing, and borrow some or all of the money they want to invest. Again, this strategy amplifies the benefit if the value of their investments rises, but also amplifies the risk if the value of their investments falls. That said, for the right investor – one who plans to invest for the long term and has a higher tolerance for risk – borrowing to invest can be an effective way to accumulate wealth more quickly. And, when investing outside a registered plan, the loan interest may even be tax-deductible.
How does it work?
Two types of investment loans are 100 per cent loans and multiplier loans. With a 100 per cent loan, the investor borrows the entire amount he or she plans to invest. Some lenders offer 100 per cent loans ranging from $10,000 to $300,000. With a multiplier loan, the investor already has some money to invest, and the lender multiplies the value of the investor’s capital by up to three times, with loan amounts that can range from $10,000 to $1 million.
Regardless of the loan type, the overall strategy is usually the same. The investor borrows a lump sum, invests the money and keeps any investment growth, while paying interest on the loan. The key to a successful investment loan strategy is ensuring that the return on the investment is significantly higher than the interest on the loan – providing some leeway in case interest rates rise – and that the return is relatively stable, experiencing little volatility. That means the choice of investment is critical: it should provide solid performance with low risk.
Investors should be aware that they must be disciplined about paying back the loan because, unlike a mortgage, investment loans often don’t require that some principal be repaid with every payment.
What happens when investments rise – or fall?
An investment loan increases the amount of money an investor has available to invest, which amplifies any gains or losses. For example, if you invest $10,000 and get a three per cent return in one year, you could make $300. If you are able to invest four times that amount in the same investment with a 3:1 multiplier loan – $40,000 – you could make four times as much that year: $1,200. Compound stable returns annually over 10 years and the non-leveraged gain could be $3,439.16, while the leveraged gain could potentially be $13,756.66.
However, let’s say that instead of earning a three per cent return in one year, the investment decreases in value by five per cent. In that case, a $10,000 investment would be worth $9,500, a loss of $500. A $40,000 investment would be worth $38,000, a loss of $2,000, and the full loan balance of $30,000 plus interest is still owing. Negative returns over time may prompt the lender to call the loan and require that it be repaid – in the worst case at a time when the investment value is worth less than the loan, requiring the investor to dip into other savings to pay off the debt.
Is it right for you?
Investors who are thinking about borrowing to invest should consider their time horizon, risk tolerance and the amount of debt they already have. They should be able to count on enough income to cover loan payments and taxes due on potential investment growth. They should also evaluate whether they can reliably earn returns that are significantly higher than the interest on the investment loan.
If you’re interested in finding out more about investment loans, speak with your advisor. He or she can help you weigh the benefits against the risks and decide if this approach is right for you.
INVESTMENT LOANS AT A GLANCE
- Potential for greater gains
- Interest may be tax-deductible
- Interest-only payments often available
- Potential for greater losses
- Interest rates may rise
- Need a plan to pay back the principal as well as interest
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