Borrowing to buy investments can be an effective way to boost your potential returns. This is called using leverage. If your investment increases at a rate that is higher than your borrowing costs, you can make money. But taking on debt involves more risk than paying for an investment outright with cash.
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What are the different ways you can borrow to invest?
Borrowing money to buy investments is called using leverage. If your investment increases in value at a higher rate than the costs of borrowing, then you could make a profit. However, this can be risky. If your investment doesn’t increase in value, you’ll end up owing more money to repay the amount you borrowed.
All loans have repayment requirements. These depend on the type of loan, how much you borrow, and other factors like the term of the loan and your personal credit history. You can expect to be required to repay the original amount plus interest. There may also be minimum monthly payment requirements.
There are four main ways you can borrow money to invest:
1. Take out a loan or line of credit
You may be able to take out a personal loan or line of credit from your bank or financial institution. A line of credit will likely be pre-approved up to a set limit. This limit can change based on your history of borrowing and repaying what you borrow.
The interest rate you pay on a line of credit is typically a variable rate that will change as the prime interest rate changes. The prime rate is set by the Bank of Canada.
2. Borrow from your home equity line of credit
Borrowing against your home is a type of line of credit that is secured, meaning that your financial institution will use your home as collateral. The interest rate is also variable, meaning that if the prime interest rate increases, so will the interest rate you owe on your loan.
Some investors choose this option in the hope that the investment they buy will not only cover the loan and related borrowing costs, but also generate extra income. The downside is that if the investment does not succeed, you could be putting your equity, and possibly your home, at risk.
3. Buy on margin
Buying on margin means borrowing money from your investment firm to buy an investment. The margin is the amount you must pay up front. For example, if your broker requires a 30% margin then you would be allowed to borrow the remaining 70% to fund the investment. The margin amount may be different depending on the type and amount of the investment.
In order to buy on the margin, you must have a margin account. This type of investing cannot be done in registered accounts such as a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA).
Buying on margin can be very risky. You could lose more money than you originally invested.
4. Short sell stocks
Investing in stocks — or shares — usually means buying shares with the hope that the value will increase in price, resulting in a profit. The opposite is the case with short selling. When you short sell a stock, you borrow shares from your investment firm because you think that the price of the stock is going to fall. If this happens, that means you can repay the original price of the stock back to your investment firm, and keep the profits.
However, if the stock price rises, you could lose more money than you originally invested. If you decide to borrow money, make sure you have a plan to repay the loan. The longer you take to repay, the more you will end up paying in interest, along with the original amount you borrowed.
What are the risks of borrowing to invest?
Whenever you borrow money, you will need to repay the amount you borrowed plus any interest you owe. The main risk of borrowing to invest is that you’re not guaranteed to make back the amount you borrowed. That’s because your investment could decrease in value.
If you rely solely on investment returns to cover your borrowing costs and your investment falls in value, you could end up defaulting on the loan. If you put up your home, or other investments, as collateral for the loan, you could lose them as well.
Before you take on any loan, ask yourself these three questions:
- What is the interest rate on the loan? The higher the rate, the more it will cost you to borrow the money in the long run.
- When will you be able to pay back the loan? If you don’t have a clear answer, reconsider whether it’s worthwhile to borrow the money.
- How much debt do you already owe? If you’re already paying off high-interest debt, for example on credit cards, you may be better off working to pay down this debt before taking on more.
If you’re considering borrowing in order to contribute to your RRSP, make sure you’ve compared the benefit of the tax deduction you’ll receive with the cost of repaying the loan. Interest you pay on money you borrow to invest in an RRSP is not deductible. It can add up and offset the initial benefit of making the contribution. Instead, you could consider what amount you’d end up repaying for the RRSP loan, and make regular RRSP contributions in those amounts rather than borrowing.
What do you need to know to pay back what you borrow?
Having a plan to pay back a loan means knowing the answers to a few different questions up front. Most importantly, you should know:
- How much it will cost you to repay the loan. This includes interest, as well as any other fees or commissions involved.
- When you’ll need to repay it, and how much you’ll need to repay each week or month to do so.
- What source of funds you’ll use to repay the loan.
- Whether you’re comfortable taking on debt for an investment that may fluctuate in value.
- Whether you need to put up any collateral for the loan, and if you can afford to lose it. Any asset used as collateral can be taken by a creditor to satisfy the loan.
Remember that there is no such thing as a low-risk, high return investment. Investments that tend to be high return are usually also higher risk. If you borrow money to invest, make sure you have a plan to repay the loan.
Use this calculator to see how long it will take you to pay down debt at different interest rates.
Summary
- There are several ways to borrow to invest, including a personal loan, home equity line of credit, investing on margin, or short selling stocks.
- When you borrow money to invest this is also called leveraged investing.
- Any amount you borrow must be repaid, whether or not your investment increases in value.
- If your investment doesn’t increase in value, you’ll end up owing more money to repay the amount you borrowed.
- If you borrow money to invest, make sure you have a plan to repay the loan.
