Borrowing to invest: Smart bet or risky gamble?

Borrowing to invest, or “leveraged investing,” is a popular strategy among seasoned investors.

While it might initially seem risky, the potential rewards can be substantial, offering an exciting opportunity for growth. If you’ve ever taken on a mortgage to buy a home, you’ve already used leverage to invest in real estate. So, why not consider doing the same in the stock market?

This guide explores everything you need to know about borrowing to invest in Canada: why it works, how to do it, and what to watch out for. We’ll also dive into different borrowing options and discuss the scenarios where it makes sense to leverage debt for higher returns.

Why borrow to invest?

The main appeal of borrowing to invest is to increase your returns.

However, it's crucial to understand that this strategy also magnifies losses.

Let’s say you have $1,000 to invest and borrow another $1,000, giving you $2,000 to work with. If you earn a 30% return, your investment grows to $2,600. You pay back the $1,000 loan and keep the remaining $1,600. That’s a 60% return on your original $1,000—an amplified gain.

But remember, this also means that if your investment declines, you could end up owing more than you invested. This is why understanding the risks is key.

Leverage also offers tax advantages. In Canada, capital gains are taxed more favourably than income, and investment interest expenses are often tax-deductible. This can reduce the net cost of borrowing and increase your after-tax return.

Moreover, leveraged investing can free up cash flow. You might have locked-in investments, such as GICs or an RRSP, that aren’t easily accessible. Borrowing can let you invest without liquidating these assets and triggering penalties or taxes.

Borrowing money to invest in your RRSP - a mathematical example

If you take out a $25,000 loan to contribute to your RRSP, you’ll receive a significant tax rebate of approximately $10,853 (based on Ontario’s marginal tax rate for an income of $100,000). This tax rebate, when used to pay down the loan, reduces the remaining loan amount to $14,148. To pay off this loan over five years at an interest rate of, let's say, 6%, you’d need to make monthly payments of about $274, totalling $16,411 over the term.

Consider this: if your existing $75,000 investment grows at a promising 7% annually, its future value in five years would be around $105,191. The $25,000 investment made with the loan would grow to approximately $35,006. After accounting for total loan payments, the net gain from this leveraged strategy would be around $30,638. This suggests that borrowing to invest in this scenario could be worthwhile, as the investment’s growth outpaces the cost of borrowing, resulting in a positive net gain.

How to borrow money to invest

1. 1.

   Margin accounts: Margin accounts let you borrow directly from your brokerage to buy securities. They offer a convenient way to access funds, often allowing you to borrow up to 50% of your investment’s value. While this makes leveraged investing easier, be aware that margin calls can force you to sell at a loss if the value of your investments drops. 

2. 2.

   Personal Line of Credit (LOC): A personal LOC can provide a flexible alternative if you don’t want to use a margin account. You’ll typically face a fixed interest rate plus prime, making it easy to predict borrowing costs. Remember, however, that you’ll need to make minimum monthly payments.

3. 3.

   HELOCs (Home Equity Line of Credit): HELOCs are secured lines of credit against your home and usually come with lower interest rates than other types of borrowing. The interest on a HELOC is tax-deductible if used for investments, but keep in mind the risk: the bank can demand repayment in full at any time.

4. 4.

   Personal Loans: Personal loans can offer a simple borrowing option with fixed monthly payments. They’re less flexible than LOCs or HELOCs, but they provide cash upfront that can be transferred to your brokerage account. Platforms like Loans Canada and LoanConnect can help you find competitive rates.

The risks of borrowing to invest

While borrowing to invest can amplify returns, it also magnifies losses. Here are some of the risks:

• ❌ Amplified losses: Just as leverage can boost your returns, it can amplify your losses. If the value of your investments declines, you could end up owing more than you invested. This can lead to serious debt and credit issues, particularly if your lender demands repayment.
• ❌ Interest costs: Borrowing costs can cut into your returns. For short-term investments, the cost of interest might be negligible. However, interest expenses can become substantial for longer-term strategies or more significant amounts. Always factor in interest costs when calculating your potential ROI.
• ❌ Market volatility: Markets don’t always go up. Leveraged investing works best when markets are rising, but your losses can add up quickly if they decline. Timing is key; borrowing when markets are down can lead to significant gains, but your losses could outweigh the benefits if the downturn persists.

When does borrowing to invest make sense?

Borrowing to invest isn’t for everyone. Here are some scenarios where it might be worthwhile:

• 👩‍🎓 Young investors: If you’re early in your investing journey and have a long time horizon, leverage can help you achieve “time diversification.” This concept refers to the idea that by borrowing early, you can maintain consistent exposure to stocks over your lifetime, potentially increasing your returns as you benefit from the long-term growth of the stock market.
• 📉 During market declines: Investing during a market downturn can be lucrative, as stocks are “on sale.” Historical data suggests that markets tend to rebound sharply after significant declines, making this an ideal time to leverage up.
• 💰 Liquidity constraints: If your assets are tied up in registered accounts or locked-in investments, borrowing can allow you to seize a timely investment opportunity without triggering penalties or taxes. For instance, if you come across a promising stock during a market downturn, you can use leverage to invest in it without having to sell your existing investments.
• 🏦 RRSP and TFSA Loans: Borrowing to “catch up” on unused RRSP or TFSA contribution room is another smart strategy. This involves borrowing to make a lump sum contribution to your RRSP or TFSA, which can potentially generate higher returns while paying back the loan over time.

Related reading: RRSP loans

Checklist for borrowing to invest

Before taking the plunge, ensure you meet these criteria:

✅ Cash flow: You have enough cash flow to cover monthly interest payments, even in the event of a loss or job loss. 
✅  Risk tolerance: You understand that leverage amplifies both gains and losses and are comfortable with this risk.
✅ Time horizon: You plan to invest for at least 10 years to mitigate market volatility.
✅ Diversification: You’re prepared to invest in a diversified portfolio, primarily through index ETFs.

Should you borrow to invest?

Borrowing to invest is not a strategy for the faint of heart. It requires careful planning, discipline, and a solid understanding of risks and rewards. However, when done right, leveraged investing can lead to significant gains over the long term.

Whether you’re a young investor looking to diversify or a seasoned trader aiming for higher returns, borrowing to invest could be a smart move. However, it's important to remember that leveraging should always be done responsibly. Assess your financial situation, manage your risks carefully, and always use leverage with caution.

Bridget Casey Author

Bridget Casey Author

Bridget Casey is the award-winning entrepreneur behind Money After Graduation, a Canadian financial literacy website aimed at 20 and 30-somethings. She holds a BSc. from the University of Alberta, and an MBA in Finance from the University of Calgary. She has been featured as a millennial financial expert by Yahoo! Finance, TIME Magazine, Business Insider, CBC and BNN. Bridget was recognized as one of Alberta's Top Young Innovators in 2016.

Robb Engen Author

Robb Engen Author

Robb Engen is a leading expert in the personal finance realm of Canada and is also the co-founder of Boomer & Echo, an award-winning personal finance blog.

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