The lure of low rates can lead to a risk trap
With interest rates so low, and stock markets hovering around all-time highs, many investors are looking to borrow for investment purposes, especially since the interest on an investment loan is tax deductible. While this might look attractive on the surface, borrowing to invest can be a perilous experience – one that you undertake at your own risk.
Borrowing to invest in stocks is certainly seductive when markets are rising and rates are low. And it’s certainly quite popular now. According to monthly statistics from the Investment Industry Regulatory Association of Canada (IIROC), some $21.4 million was invested in Canadian margin accounts as of the end of May.
The promise of gains – with one big proviso
Borrowing money to invest – also known as using leverage – sounds promising. The idea is that you can increase the size of your investment considerably beyond the amount of your own capital. Then you pay off the loan with any gains you may realize from the larger investment. You’ll have to pay interest costs along the way, but provided you can cover this carrying charge, you stand to make the proverbial killing in the market. The proviso – and it’s a big one – is that leverage works both ways.
The fact is, leverage magnifies your gains in a rising market. But it also magnifies your losses when markets head south.
Say you invest $10,000 of your own money (your equity) and borrow $40,000 for a total $50,000 investment in an equity exchange-traded fund. Now suppose the fund gains 10%. Your investment is up $5,000. However, in reality, you have made a gain of 50% on your original equity, less the interest cost of the $40,000 loan. If the investment falls by 10%, you have actually lost a total of 50% on your equity. This is why leverage is such a risky proposition.
The dreaded “margin call”
If you’re using a margin account with your brokerage firm, and the value of your investment falls, the brokerage will ask you to put up more cash to restore the equity in your account to the broker’s maintenance margin (a margin call). If you are unable to add cash, the broker may sell your securities to increase your account equity. With a margin account, it is possible to lose your entire investment. Borrowing using a margin account is therefore recommended only for experienced short-term traders with enough cash cushion to meet margin calls.
If you borrow to invest using a bank loan or line of credit, you’ll still get the magnified upside and downside to any stock market investments purchased using the borrowed money. However, you won’t be faced with margin calls if your investments head south. Instead, you’ll have to eat the loss yourself. Basically, you’ll still be on the hook for the entire principal amount of the loan plus ongoing interest for the term of the loan regardless of the value of the investment.
Interest may be tax deductible
Typically, the cost of a loan made for investment purposes is tax deductible, provided it’s a bona fide loan made at reasonable commercial terms and legally documented as a loan obligation. This type of leverage strategy works best over the longer term and only with a principal amount whose payments you can meet comfortably when the value of your investment fluctuates. The objective is to generate a longer-term after-tax return that is greater than the after-tax cost of borrowing.
Because leverage can be both tricky and risky, it’s always prudent to consult your financial advisor before embarking on the strategy.
© 2016 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.