Is Borrowing to Invest a Good Idea and How Can You Do It?
Leveraged investing, or borrowing money to invest, is a common practice for seasoned traders investing in the stock market. This strategy involves taking on more risk, but it can significantly amplify your returns. Also, because investment gains are taxed more favorably than income, borrowing to invest is likely less risky and more affordable than you might think!
In This Article:
Why Borrow to Invest?
Undoubtedly, the biggest reason to borrow money to invest is to increase your investment returns.
For example, let’s say you have $1,000 to invest and you borrow an additional $1,000. You now have $2,000 to invest in the stock market. If you make a good investment and earn a 30% return, your investment grows to $2,600. You sell the security, return the $1,000 you borrowed, and keep the remaining $1,600 for yourself. As a result, you now have a $600 profit on the $1,000 you started with – a 60% return on your cash!
Lower Income Taxes on Investment Returns
One of the reasons leveraged investing is so favorable is because both your capital gains and dividends from the securities you purchase will receive preferential tax treatment. If you make profitable trades, only 50% of your profits will be subject to capital gains tax.
Claim Investment Losses
While it’s unpleasant to think about a trade going poorly, knowing you can claim capital losses to lower your income tax burden can make the loss easier to take. Losses on the sale of stock market securities can be used to offset capital gains the same year, up to three years prior, or carried forward for future years.
The favorable tax treatment of both capital gains and capital losses makes borrowing money to invest more attractive, because it lowers your costs of investing and reduces the financial risk of your trades.
Free up Cash Flow to Invest While Leaving Other Financial Assets Intact
Another way borrowing can make sense is when you have financial assets, but they’re not liquid to use to invest in the stock market. For example, you may have long-term investments like Guaranteed Investment Certificates (GICs) or a lot of your net worth tied up in your Registered Retirement Savings Plan (RRSP) or a company pension, where making a withdrawal could incur penalties and taxes. In these examples, it’s preferable to borrow money to invest, rather than try to cash out illiquid long-term assets.
How to Borrow Money to Invest
There are a number of ways to access extra capital to invest in the stock market. Here are the top three ways to borrow money for your portfolio:
1. Use a Margin Account
A margin account is one of the best ways to borrow to invest, because it’s likely already available at the brokerage where you already have your portfolio. This saves you the inconvenience of borrowing money from elsewhere and transferring it to your account. It also lets you more readily track your investment profits, losses, and costs because they will all be in one place.
A margin account lets you borrow money from your brokerage to purchase stock market securities in your investment account. A margin account typically allows you to fund up to 30% to 50% of a stock purchase with your own money and cover the rest with borrowed cash. This means if you’re interested in making an investment in a publicly traded stock that costs $5,000, you would only need to put up as little as $1,500 of your own money, and use the margin to fund the rest.
Your margin account will charge you interest on the amount you borrow. Typically, interest is calculated daily and accrued monthly, and is at a fixed rate plus prime. It’s not uncommon for margin accounts to charge different interest rates depending on your account balance, as well as the currency you’re trading in. Accounts with $100,000 or more in cash assets will enjoy lower interest rates than those with less. Furthermore, your margin account will allow you to borrow the amount you need as long as you need it, with no minimum monthly payments.
2. Use a Personal Line of Credit
If you don’t have a margin account with a self-directed brokerage, like one of our favorites, Questrade, or you’re not sure you want to open one, a personal line of credit is another way to borrow money to invest at a comparably low interest rate.
If you are using money from a line of credit to invest, you will need to withdraw the amount you need from the line of credit and transfer it to your brokerage account to invest in the stock market. Like the interest charged in a margin account, the interest on a personal line of credit is at a fixed rate plus prime. Unlike a margin account, your line of credit will be at a fixed interest rate regardless of how much money you’re borrowing or what currency you’re trading.
However, they will also likely require a minimum monthly payment. If you do not expect to pay back the amount you borrow in full before the bill’s due date, make sure to factor in the monthly payment as a regular expense until your trades are complete and you can repay the line of credit.
3. Use a Personal Loan
Finally, if you do not have a margin account or line of credit to draw from, you can use a personal loan. Similar to a line of credit, a personal loan provides you with cash you can deposit into your brokerage account to invest in the stock market at a fixed interest rate, and pay back on a fixed monthly repayment plan. Depending on your lender and your credit score, you may even end up with a more favorable interest rate than that from your brokerage or bank.
Here are some of our top recommendations for where you can find a personal loan to help you with that investment you’re thinking about:
Loans Canada is a lending platform that could get you $500 to $50,000 with interest rates as low as 1.99%–46.96%. With one, simple loan application, Loans Canada saves you the headache of calling around and having your credit score hard checked. You can get your cash as early as the same day and move it to your brokerage account with an transfer.
LoanConnect connects you with personal loans of $500 to $50,000 at interest rates as low as 6.99%-46.96%. Their varied lenders’ network means you can get approve, no matter your credit score. You can get approved in as little as five minute and get your funds the same day, and then simply transfer it to your brokerage account to start investing.
Downsides of Borrowing to Invest
It’s easy to see why leveraged investing is so popular. However, there are downsides before you borrow money to invest in the stock market.
Here are some of the most important factors to consider before you borrow cash to invest:
Amplified Risk and Potential Investment Debts
The main downside to leveraged investing is that while it amplifies your potential profit, it also amplifies your risk. When you borrow money to invest, your potential losses are significantly greater than if you were trading your money alone. In addition to the potential of losing all the cash you put forth in the trade, you can also lose the money you borrowed, which would leave you with added debt.
Depending on the size of your losses and the terms of the loan from your creditor, losing borrowed money in the stock market can compromise your credit score and other financial assets, as well as your ability to borrow money in the future.
Increasing Your Costs
Something to always factor into your trading calculations is the fact that leveraged investing increases your costs. When you are buying and selling securities with borrowed money, not only do you have to account for trading commissions and currency exchange fees, you also have to factor the cost of borrowing into your ROI calculations.
When you borrow money to invest, you pay interest on the amount you borrow. For short-term trades, your interest costs will likely be negligible, but for large amounts or securities you hold for weeks or months, they can become significant. It’s important to account for these costs when assessing your potential profit.
When Does Borrowing to Invest Make Sense?
Think leveraged investing is for you? Here’s a quick checklist to know if you’re ready:
- You want to take advantage of a short-term opportunity that cannot wait for you to accumulate the cash in savings to invest.
- You know your costs of borrowing, including interest charges and trading commissions, and factored them into your ROI calculations, and this move is still worthwhile for you.
- The interest rate on the cash you’re borrowing to invest is less than 10%, and ideally much lower than that.
- You know what you’re doing when it comes to investing and are making an informed trade, not gambling on a hot stock tip.
- You don’t need the money you’re risking, and can afford to lose it if they trade doesn’t pan out.
- You are not borrowing to invest inside of a TFSA or RRSP, where investment losses can result in lost lifetime contribution room.
- You have cash on hand to cover the trade if it goes badly.
- You have stops in place to minimize losses.
- You have a plan to repay the amount you borrow in a timely manner.
Borrowing to Invest Can Be Hugely Profitable If You Manage Your Risks
Borrowing to invest is a great way to earn higher returns, so long as you mitigate the risks and understand the costs. Leveraged investing is a favorite strategy of seasoned traders because of the potential for high returns. If you’ve already been investing for a few years and are looking for new avenues to increase profits in your portfolio, this might be it!
Poorly written article as it utterly fails to mention two words: “margin call”.
Sorry we couldn’t win you over JP. We’ll try to do better next time. Can’t win them all I guess.
Very informative article.
Could you also invest in proven Canadian company’s that pay dividends even inside a RRIF or TFSA and use those earnings to pay down the loan? Thank you
The short answer to your question is yes. However, you must be very careful. It’s easy to pay off the loan with your investment proceeds when your investment is doing well. When that happens, you can profit and have enough money to pay down the loan. But, if your investment loses value, particularly if the amount of value it loses is more than the monthly cost of the loan, what will you pay the loan with then? A dividend that’s paid out is usually a percentage of the value of the investment at the time. If your dividend and by extension your investment loses money and you don’t pay your loan as scheduled, interest on the loan will go up and you could quickly be paying more in interest on the loan than the value of the dividend/investment could ever make up.