Over the past few years, low-interest rates in Canada made borrowing money very attractive, especially when you plan on investing the money into purchasing assets that you think will increase in value with time. As tempting as it is to consider borrowing money to invest, is it a good idea?
Investing decisions will often come down to your investment strategy, how long you plan to stay invested, and your ability to weather changing market conditions. While many supposed “financial experts” were quick to state that borrowing money to invest was a good idea, we’re going to look at why this may not be the best idea.
We’ll explain why you shouldn’t borrow money to invest, the common reasons for borrowing money to invest, and the different scenarios surrounding borrowing money to invest.
Why Borrowing Money To Invest Isn’t a Good Idea
While using leverage to invest money has become a common topic over the years, there are many reasons you shouldn’t borrow to invest.
There Are No Guarantees With Any Investments
There are absolutely no guarantees when it comes to any investment. Some of the biggest companies in the world (like Meta, for example) have dropped significantly this year. If you had invested money in the stock market at the beginning of the year, your portfolio would likely be down. Depending on the terms of the loan, you would have issues with paying back the loan since the stocks have led to losing money.
You Could Be Stuck With Debt You Can’t Pay Off
Borrowing money to invest only works if you make a substantial amount from the investment returns to pay off the loan and the interest accrued. However, you will be stuck with the debt if the investment doesn’t pan out.
Search through forums and social media. You’ll find many stories of eager investors who lost their life savings or ended up in massive debt on crypto and the stock market in the last year because they made rash financial decisions by thinking they could perfectly time the market.
Your Investing Horizon May Not Match Up With the Market
Borrowing money to invest could work out if you time the market and cash out at the perfect time. However, nobody has a crystal ball that allows them to do this. The biggest challenge is that your time horizon could become problematic. For example, let’s say you borrow to invest to have the funds for your wedding in two years. Then the stock market tumbles, and your $100,000 investment is worth $60,000. You need the money but don’t want to sell because you’ve lost money. You would be in a dire financial situation.
You Could Be Borrowing on Incorrect Information
Many supposed “financial experts” and “crypto experts” were quick to tout that they could promise you guaranteed high returns. Anyone who has been investing for any amount of time knows that there’s no such thing as returns that are guaranteed to be high.
The biggest problem with investing success stories in the media is the huge survivorship bias. Those who hit it big with an investment rush to social media to brag, but in reality, many people have lost money over the last few years by chasing the next best investment. If you borrow money to invest based on incorrect information you found on Reddit or some social media platform, you could destroy your financial situation.
The risks are just too high for borrowing money to invest. If you’re new to investing, you must focus on the basics of personal finance. If you don’t have the money to invest right now, focus on setting a budget, learning ways to increase your income, and building up your savings account.
READ MORE: The Best Personal Loans in Canada
When Does It Make Sense to Borrow Money For Investing?
Does it make sense to borrow money to invest? We’re not in favour of it, but we’re going to look at the common reasons why people borrow money to invest. It’s important to remind you that borrowing money to invest for any reason is extremely risky, and you should consult a financial professional before making a decision.
Borrowing Money To Build Your Credit History
If you’ve never borrowed money, banks and other creditors have no way of knowing if you’re likely to make your payments on time since you have no credit history. Without a credit history, they may not offer you a reasonable interest rate when you want to take out a mortgage, car loan, or line of credit. You may even be denied a loan.
If you borrow to invest in an RRSP, TFSA, or non-registered account and pay back that money in a responsible and timely manner, you are more likely to get a preferred interest rate on your next loan because you’re going to build your credit profile.
Borrowing Money To Maximize Returns
The longer you leave your money to grow, the better off you’ll be, thanks to the magic of compound interest. How so? Because you don’t just make money on the funds you invest, you also earn income on all your previous investment returns. When you combine the power of compounding with a proven low-fee investment strategy offered by a robo-advisor like Wealthsimple or a discount broker like Questrade, your savings can snowball over time.
Borrowing Money To Lower Your Tax Burden
Since the government wants to encourage investment in Canadian companies and personal retirement savings, some attractive income tax benefits come along with various types of investments.
While it’s tempting to want to borrow money to invest because the idea seems solid in theory, the problem is that many things can go wrong in execution. You could end up in financial trouble because now you have to stress about paying this money back.
So, when does it make sense to borrow money for investing?
- Using your home equity to make money - If your home went up in value, you could be sitting on equity that could be used to bring in more money for you.
- Maximizing RRSP contributions for tax advantages - RRSP loans have become popular options for borrowing to invest in Canada as folks look to save money around tax time.
Once again, we have to stress the risks of borrowing money to invest. Below are options for borrowing money to invest, but we still urge you to do your due diligence before making any decisions.
Leveraging Home Equity Line of Credit (HELOC) To Invest
Using funds from a home equity line of credit to invest would give you access to a significantly larger sum of money (and a better interest rate) since the equity in your home secures the funds. Of course, that also increases your risk since your home could be at stake if you can’t make the interest payments.
If you aren’t disciplined about paying back the money you withdraw from your HELOC, you could end up paying more in total interest over time, even if your rate is low.
By the same token, your tax deductions for the interest charges could be sizable, and they might even lower your taxable income enough to qualify for an increase in income-tested benefits, such as the Canada Child Benefit or Old Age Security.
Borrowing and investing a larger sum of money might make it psychologically harder for you to stay invested if there’s a market downturn. For example, a 20% annual market loss on a $10,000 investment is $2,000, but the same percentage loss on a $100,000 investment is $20,000. And that loss may feel even more acute when you add the fact that your investment may be worth less than the outstanding debt on your HELOC.
To recap, leveraging your HELOC to invest could be a smart strategy if you:
- Have a lot to gain through interest tax deductions.
- Are confident you’ll be able to make your interest payments with ease and have a plan to pay back the principal;
- Plan to invest for at least 10 years and stay in the market even if you experience sizable annual losses.
- Understand that your home is at risk so you can’t be using this money on speculative assets.
Should I Borrow To Invest in an RRSP?
Another way borrowing to invest can give you a tax advantage is by taking out an RRSP loan. Many people do this to use all their allowable RRSP contribution room, which they can then deduct from their taxable income in the year they make the contributions.
Using our earlier example of a $10,000 loan at a 5% interest rate for a three-year term and average annual investment returns of 4%, here’s the math on an RRSP loan:
- Costs of borrowing - About $790 in interest over three years. However, that amount would be offset by the income tax deduction for making a $10,000 RRSP contribution. If your marginal tax rate is 30%, that’s a tax savings of $3,000, which more than covers your interest payments.
- Investment returns - About $1,250 over three years, as explained above.
- Taxes - $0 during the three years (as long as you stay invested) since all income earned inside an RRSP is tax-free. However, when you withdraw the funds, you’re taxed at your marginal tax rate.
At the end of the term, you’re ahead by nearly $3,500 ($3,000 in tax savings – $790 loan interest charges + $1,250 investment returns = $3,460). But this is the case only if you keep the money in your RRSP. If you withdraw your RRSP investment (worth nearly $11,250) at the end of the three years, you’ll get taxed at your marginal rate. Assuming it’s still 30% (it might even be higher if you got a raise and moved into a higher tax bracket), that would be a tax hit of $3,375, bringing your final tally down to a measly $85 or less in our example.
What To Consider Before Borrowing Money to Invest
Let’s assume that you’ve decided to borrow money to invest. We can’t stop you from making financial moves, especially when you know the risks involved. However, even if you’ve crunched the numbers and think you can come out ahead by borrowing to invest, there are some situations when it’s probably not a good idea, such as:
- If you’re in a very low tax bracket - The tax savings would be minimal.
- If you already have a lot of debt - You may end up defaulting on your payments, which can ruin your credit rating, making it challenging to apply for a mortgage or any loan in the future.
- If you have precarious employment - If there’s a chance that you might not have enough income in the future to afford the loan payments for the entire term, you could put yourself in a terrible position.
- If you’re prone to rash decision-making or can’t handle the risks involved - When markets plummet, selling low will wipe out any potential benefits of borrowing to invest.
Does It Make Sense To Borrow Money To Invest? Final Thoughts
Borrowing to invest may feel like a good idea, but there are plenty of reasons why this could backfire on you. Many financial experts often warn you about investing in risky or speculative assets by suggesting that you only put in money you could afford to lose. Experts warn you because you work hard for your money and don’t want you to lose it all.
Borrowing money to invest is extremely risky, and you could find yourself in debt that you’re stuck with paying off for years. You don’t want to destroy your finances because you took on a risk with more cons than pros.