Borrowing to invest: Risks and benefits

An investor can borrow to invest in a portfolio of securities in order to increase his chances of reaching his long-term financial goals. However, the issues involved are complex, and it is very important that they be fully understood.

 

 

 

How does it work ?

In the same way an entrepreneur borrows to invest in his company, allowing it to grow more quickly and generate additional income, a “Leveraged investment” can help an investor achieve the same goal. It consists of borrowing money, in one form or another, for investment purposes.

 

Key benefits of Leveraged investments

• You’re investing a large sum of money right from the outset, which will allow you to benefit from the returns on this large amount over a long period of time. This should ultimately result in a greater capital accumulation than gradually investing smaller sums over
time, with or without borrowing.

• Typically the interest rate charged on an investment loan will be the prime rate, which is usually the lender’s lowest rate.

• Interest expenses incurred on an investment loan can generally be deducted from your taxable income, which reduces the cost
of servicing the loan and makes the strategy more attractive.

• You don’t have to liquidate or pledge your real estate as security.

• The amount you can borrow is usually greater than with a simple secured credit margin.

• Guarantees required by lending institutions on such loans are generally less binding.

 

Key risks of Leveraged investments

• Liquidity risk: If the interest rate on the loan fluctuates upward, your monthly payments will also increase. Since an increase in interest rates usually affects the stock market negatively, your portfolio’s performance might suffer at the same time. As well, over the long period during which you’ll be using the investment loan, your personal income might drop, which could make it difficult or impossible for you to continue meeting your interest payments.

• Market risk: This risk exists with all investment strategies but it is magnified with a leverage strategy since your rate of return has to be high enough to cover the cost of servicing your loan. Also, you will have to reimburse the borrowed capital at some point. If the value of the investment you purchased with the loan is lower at that point than the amount borrowed, you will be out of pocket for the difference.

• Tax risk: The deductibility of interest you pay on investment loans is an important element in making a leverage strategy work from a financial perspective. Revenu Québec has already imposed limits on the amount of interest that can be deducted on its provincial tax return, and the Federal government has announced its intention to make changes in this area as well – which could make the use of leverage in investing far less attractive. Furthermore, the impact of taxation on investment returns must also be considered – interest income, dividends, and capital gains and losses are each taxed differently.

• Emotional risk: While fear and greed exert powerful influences in the financial markets, they aren’t the best factors on which to base investment decisions. If you experience fits of anxiety when your investments take a downturn, you should avoid using leverage since it will only magnify any short term losses. Nowadays, stock market results are an integral part of the daily news, so you will be constantly reminded of the consequences of your investment decision – which could lead to a lot of sleepless nights. Similarly, if you think you’re going to get rich quick using “other people’s money”, investment loans are not for you. Leverage can make a good investment strategy better, but it doesn’t work miracles.
Patience, discipline and 10-year time horizons are required – which don’t usually fit with a “get rich quick” mindset.>
 

The borrow-invest strategy in 5 points :

 

Factor 1 : Invest in stocks

In simple terms, the strategy behind using leverage for investment purposes is to borrow money and make an investment that will generate a higher aftertax eturn than the after-tax cost of servicing your loan. You must therefore focus on asset classes and assets that stand the best chance of delivering such returns.

Factor 2 : Consider your investor profile

Before you decide on any type of leveraged investing, make sure you consider your investor profile very carefully, since the probability of turning a profit with such a strategy is directly linked to the notion of investment risk premium. If your profile is somewhat conservative, an investment loan is not suitable for you.

Factor 3 : Focus on the long term

It takes many years – usually at least 10 – for an investment loan to show its true potential.

Factor 4 : Be aware of the impact of taxation

The deductibility of interest charges for an investment loan is an integral component of a leverage strategy. It is important to ask your accountant or fiscalist if the contemplated strategy will have the desired fiscal impacts.

Factor 5 : Choose your repayment method carefully

Should you repay the loan interest only, or both the capital and the interest? You can get the most out of your leverage loan by paying only the loan interest, and not repaying any of the capital until the end of the loan’s term, typically when you liquidate your investments.

As you can see, the leveraged investment has many benefits but also many risks. In my opinion, I would only use this strategy at a time of highteigned turbulence in the markets and following a large drop (example: end of 2008). Using leveraged investments when stocks are very depressed would greatly increase the potential return of this type of strategy.

This article only touches the surface when it comes to leveraged invesments. If you would like more information on this matter, please do not hesitate to contact me.

Cathy Duval, CFA