Borrowing to buy investments, also known as leverage, can be a way to boost your gains but it can also lead to larger losses. If your investment increases at a rate that is higher than your borrowing costs, you can make more money than you would have had you only used your own cash. But leverage involves much more risk than paying for an investment outright with cash. So, you can end up with larger losses as well.
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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 very risky. If your investment goes down in value, your losses will be greater.
Consider these examples:
Example 1:
You invest $1,000 in Stock X and borrow $1,000 on margin.
Stock X goes up 50%.
Your $2,000 investment grows to $3,000.
If you were to sell the investment and pay back the loan and interest, you can walk away with a profit ($3,000 – $1,000 initial investment – $1,000 loan less interest owing ($100) = net profit of $1,000 less interest of $100 = $900
If you had only invested your own money, your profit would be $500.
Example 2:
You invest $1,000 in Stock Y and borrow $1,000 on margin.
Stock Y goes down 50%.
Your $2,000 investment drops to $1,000.
You owe $1,000 loan plus interest of $100.
You still must make the payments on the loan and interest. You may be required to provide additional collateral* or be forced to sell the investment to repay the full loan and interest.
*Volatile stocks can trigger margin calls fast, which could lead to permanent losses.
If you had only invested your own money, you would have a decreased value of $500.
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. Make sure you review any loan contract such as a margin loan contract carefully and understand the potential consequences of the terms included.
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 typically 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 not only your investments but also your home, at risk. You may have to sell your home to pay back the loan.
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.
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. This is because investment firms impose several conditions on margin loans that could negatively impact an investor when the value of their investment declines. One of the most significant is the margin call. Investors are required to maintain a certain level of collateral in their account so the investment firm knows they will be able to pay back the loan. If the value of the securities in the investor’s account falls below this threshold, the investment firm will issue a margin call. The investor then has a period of time (could be hours or days) to bring their account value back above the threshold, either by depositing more cash or selling securities in the account.
If the investor does nothing and the account value remains below the threshold, the investment firm will decide which securities to liquidate in the investor’s account.
Margin trading risks:
- Irrecoverable losses – You may be forced to sell securities in your account due to margin calls and if so, the losses are permanent and you cannot hold the securities to see if it rises in value.
- Tax liabilities – When you sell securities or the firm forces you to due to a margin call, then you may incur tax liabilities.
- Damage to credit score – Your credit score may drop if you fail to repay the margin loan to the investment firm.
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. Typically, short selling can only be done through a margin account.
What are the risks of borrowing to invest?
Borrowing to invest amplifies losses if the investment goes down in value.
Whenever you borrow money, you will need to repay the amount you borrowed plus any interest you owe. And there is no guarantee you will make back the amount you borrowed through investing. 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 for investment purposes, ask yourself these five 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. And the greater the investment returns need to be in order to just break even.
- 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 rather than taking on more. If you already have a large amount of debt payments relative to your gross income (higher than 35%) or have a debt load greater than 30% of your net worth, leveraging may not be appropriate for you.
- Do you have a low risk tolerance? Leveraging may not be appropriate if your risk tolerance is low.
- Do you understand how margin trading works? Leveraging may not be appropriate for you if you don’t understand the complexities of how leverage or margin trading works, including how you could have potential losses.
If you’re considering borrowing 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 high risk.
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.
- All investments carry risks. Leveraged investing magnifies those risks.
- If you use leveraged investing, such as a margin account, you should fully understand how it works and the risks involved.
- Consider whether leveraged investing is appropriate for you.
