The idea of borrowing to invest is often promoted as a way for investors to top up their retirement savings or, for younger people, to kickstart their portfolios.
While there are benefits to borrowing to invest to pump up investment returns, there’s risk to using leverage given there are no guarantees the investments won’t drop in value in the future.
Since borrowing to invest — and the tax benefits of doing so — can be complicated, most people should seek the help of an investment advisor, says Susan Watkin, an accountant and spokesperson for TurboTax Canada.
“If I am going to borrow money to invest, is the benefit of the investment going to be worthwhile for me to incur this debt? What kind of debt can I get and will I be able to afford that debt?”
Ultra-low interest rates have already prompted many to utilize leverage based on monthly client margin debt (money lent out by brokers for investors to buy or short a stock), which hit a record high last year, according to the Investment Industry Regulatory Organization of Canada.
Interest rates remain tempting for those weighing the option of borrowing to pad their portfolio; however, stocks are currently expensive, with equity markets near all-time highs (a function of low rates).
“Borrowing to invest is generally a good thing to do but you need to be careful when doing it,” says John De Goey, a portfolio manager with Wellington-Altus Private Wealth Inc. in Toronto.
He considers equity markets pricey, especially U.S. equities, which have enjoyed gains in 12 of the last 13 years.
For Canadians who are determined to utilize borrowing for investments, he advises buying “on-sale” investments. “You need to be careful; you need to be selective, and you need to watch prices and valuations.”
The big allure of using leverage is the potential to cut personal income taxes, particularly for high-income earners.
If, for example, a top income earner borrows to invest in a non-registered portfolio of dividend-paying blue-chip stocks, interest payments are tax-deductible.
“If you are a one-percenter making $250,000 a year, you are able to deduct 53 per cent of that (annual interest charge),” explains Mr. De Goey, based on the top income bracket for Ontario taxpayers. “That’s a big deduction.”
It’s a strategy that makes sense for high-income families that already have fully utilized registered savings vehicles, such as registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs) and have extra cash left over.
One example of Canadians using leverage is middle-aged homeowners who have recently paid off their mortgage and choose to use that freed up cash flow to service a sizeable investment loan.
Another leveraged investing strategy becoming popular in Canada has been dubbed a “debt flip,” which involves transforming non-deductible debt such as a mortgage into a tax-deductible investment loan.
“I think it’s very, very attractive right now,” says Scott Plaskett, managing partner and chief executive of Ironshield Financial Planning of Toronto.
He gives the example of a couple with $100,000 remaining on their mortgage and an equal amount in a non-registered investment portfolio.
In that scenario, the couple would sell the portfolio to pay off the mortgage and turn around and take a secured loan (or borrow through a line of credit) using the home as security. The difference is that payments on the $100,000 loan are now tax-deductible.
The amount that can be deducted will depend on a person’s tax bracket.
“Turning your interest into a tax deduction is the equivalent of an RRSP contribution,” Mr. Plaskett says.
“Whenever I see people who have personal debts that are not tax-deductible and personal investments that are non-registered, I always say, why don’t we take those, pay them off and buy [the investments] back again. The debt is going to be the same but now we have a tax deduction that we just found for you.”
Canadians receiving a sizeable increase in annual income, inheritance, or even a large bonus are also good candidates for this approach.
Rather than put these windfalls in RRSPs or a TFSA, “you need to look at it from a bigger picture and maybe there is a way to get a bigger tax deduction,” he says.
Borrowing to invest has obvious appeal to older, established Canadians who find themselves in higher tax brackets and can afford to make payments on a large investment loan. But what about younger Canadians with more modest incomes and, likely, smaller investment holdings?
Younger investors “don’t have the financial flexibility and they have other priorities,” Mr. De Goey says.
This group, largely composed of millennials in their 30s, should be focused first on registered education savings plans (RESPs) for children, mortgage/rent payments, as well as RRSP and TFSA contributions.
Concentrating on RRSPs and TFSAs will likely provide a better tax benefit for that group, Mr. De Goey says.
“It is not like borrowing to invest is a bad option; it’s just that there are consistently, at that stage of life, better options.”
Ms. Watkin of TurboTax says investors can use one of TurboTax’s free online calculators to run various scenarios to help them decide if it makes sense to borrow to invest.
“The RRSP calculator can help you figure out the impact of your investment, or you can even start a tax return using TurboTax Online because it is free until you file,” she says. “Put your income information, and any other deduction or tax credit details, in there and see if it makes a difference for you today and that can help you determine if it makes sense for you to make any contributions before the March 1st RRSP deadline.”
TurboTax Online Deluxe, which is designed for those wishing to maximize tax credits and deductions with slightly more complex tax situations, might be the best product fit in those cases.
If filers want an extra set of eyes ensuring they’ve gotten the most out of their return, they can opt for the Assist & Review or Full Service options, to get help from a real tax expert.
Ms. Watkin adds that TurboTax.ca also features calculators for income tax calculations, RRSP contributions, and self-employed individuals.
This article was originally published by The Globe and Mail – How to know when it’s best to borrow to invest