Should you invest with borrowed money?
In this video, you will understand how investment loans work
And will borrow to invest going to help you or gonna break you!
Hey guys! This is Thomas!
Better Mindset | Better Life!
Last week I mentioned that
when you borrow to invest on certain investment.
The interest payment can have a tax deduction purpose
It's another way for you to reduce taxes
beside contributing to your RRSP.
Some people say it’s a smart move
to use other’s people money to invest
it boosts the investment return
plus you get an extra tax advantage.
Where other might say this is for the rich only.
Having a debt always create more liability.
so how do you justify it?
Make sure you watch the entire video to get the full picture!
So first thing first,
When you are borrowing money from other parties.
You are doing an OPM, other people’s money.
And you created a debt
There are two kinds of debts.
The good debts are using other people’s money
to generate more asset and cashflow.
Where the bad debts are the opposite,
creating more liabilities and hurting your cashflow
Imagine today if you want to buy a place.
usually you will not have enough money to pay for everything upfront.
So what do you do?
You will go to the bank and ask for a mortgage.
Leverage the banks money to get the property.
Then you pay the money back to the bank
in a longer time frame with an interest.
You get the place, bank gets the interest, everyone is happy.
A good mortgage, student loan, investment loans
are considered as good debts
because it helps you get better value in a shorter time frame.
Verus if you are over extending the credits cards for vacation,
newer cell phones, beers and hobbies.
Those are terrible debts
and if you cannot keep up with the payment
You will end up in a credit card hamster wheel
Using others people's money is always a double-edged sword.
Always ask yourself what is the purpose of the loan.
And what can you do with the money.
So how does investment loan able to speed up saving?
Let’s start with the tax advantage first.
When you are filing your taxes,
under line 22100, the carrying charge.
it said you can have tax deduction on the interest
if you borrow to invest on things that yield investment income.
Like an equity bond mixture portfolio.
Or companies that yield dividends.
Let’s take a closer look.
For instance,
Tom and Mary both making $100,000 per year
and their marginal tax bracket is at 40%.
They each wants to invest $4,000 in a non registered account
Tom invests in a mutual fund with 80/20 ratio,
80% in equity, 20% in fixed income.
Assuming the investment gives 3 different returns,
4% 6% 10%
Tom gets $160, $240, and $400 as profit
Now because this is in a non reg account,
it needs to be taxed so the net profit is lower
On the other hand, Mary decides to borrow to invest
She borrows $100,000 and
invest in the same 80/20 mutual fund as Tom did
We assume the cost of borrowing is at 4% (Prime + 1)
which she needs to pays $4000 a year as interest
Right off the bat, the $4,000 can be tax deducted
so she gets back $1,600 in taxes
Now let’s talk about the investment return.
Let’s have the same three scenarios again.
The 80/20 fund yield 4% 6% and 10%
for 4% return, the $100,000 will gain $4,000 now
the $4,000 partially considered as capital gain,
some are interest income.
So roughly 60% of the investment gain will be taxed
To put it in numbers
The 60% of the $4,000 which is
$2,400 will be consider as taxable income
Mary needs to paid $960 as tax ($2400 X 40% tax bracket)
the net income becomes $3,040
plus the $1,600 tax saved,
she will receive $4,640 in total
same goes to 6%, the $100,000 gives $6,000
Mary paid $1440 as tax
She will get $4,560 plus the $1,600 tax she saved
10% the $100,000 gives $10,000
$2400 as tax, and so the net is $7600 plus the $1,600
Assuming she sell everything in a year.
the actual out put for Mary is $4,000
for the return above, Mary is making money.
and even at 4%
where the investment return breaks even with the cost of borrowing,
she still makes money because of the tax return.
That’s the power of investment loan.
It amplifies the return.
For the same 10% return,
Tom is making $400, where Mary is making $9,200 already
Mary is making more than a double compare to Tom
Same Time Frame, Same Investment.
Different Strategies, Different Outcome.
But it also amplifies the lost as well.
Say if the investment gives -1% return
The $100,000 will be down to $99,000
Mary doesn’t have to pay investment tax
She still gets the tax return of $1,600
But her initial cost is $4,000,
plus she owns the bank $1,000 so total of $5,000
net Mary is still down $3400.
Versus Tom is down $40 bucks.
So the key is about the risk and the return
Where can I find a low borrowing cost
with a decent investment return
there are two ways that you can borrow money
with a relatively lower borrowing cost
compare to credit card or private loan.
One is through the home equity line of credit.
The other one is through specific investment loan bank
The home equity line of credit is where
using your property as a collateral.
The interest rate is usually sitting at prime.
And you can use the money however you want to.
The maximum that you can borrow depends on your property’s value.
Even though the interest is low with wider options
If you cannot service the loan,
the bank has the right to takeover the property.
Compare to the other one.
The interest on investment loan program is usually varies at
prime + 1% to prime + 1.5%.
You have to put the money into a specific investment
usually in mutual fund or segregated fund.
But the good side is most of the loan programs out there
do not require asset as collateral.
The maximum you can borrow is 1:1 to your personal asset.
Which means if you have $100,000 asset,
you can only borrow up to $100,000.
Note that most of the investment loans out there
do not contain a margin call.
Which means they don’t have to force sell
or require more capital added
when the investment failed to perform.
So, what investment should we consider then?
If we break down the rate of return to
1% 3% 5% 10% 15% 20%
You usually see 1% in a saving account
3% in a term deposit or bonds
5% is the average Canadian stock market
You will find 10% - 15% return in the US stock market
And any thing higher will be in the high-risk investment zone.
But all these returns are based on their past performance
and do not guarantee their future return.
It is important to do your own research
or talk to a professional for advice.
Should we consider investment loan?
When the return is bigger than the cost of borrowing,
then Yes, good idea to do it.
When they are equal,
you still gain because of the tax advantage
When the return is lower than the cost of borrowing,
then this is where you have to pay extra attention
and have contingency plan.
And to answer the question,
Is borrow to invest going to help you or to break you.
Here are my 2 cents:
It’s going to help you if you are comfortable taking risk
you are not relying on it to pay your daily bills
And you plan to invest in a longer time frame
The analogy that I like to use
like driving a super nice sports car.
It helps you to get to your destination faster.
But if you don’t know how to drive one,
and don’t watch out for the traffic light.
you will end up in car crash.
It is important to talk to your financial advisor for advice!
There are couple FAQ when it comes to investment loan.
No 1. I am young, should I consider borrow to invest?
In a 2010 book, Ian Ayres and Barry Nalebuff,
two professors at Yale both suggested it make sense for young investors
to use leverage strategy early.
Because when we are young,
we have much less cash to invest,
but we have longer time frame to invest.
The longer timeframe that we invest,
the more favourable outcome will going to be.
Both professors found using leverage strategies when younger,
the return would be substantially higher
compare to the traditional investment strategies.
2. Can I use my personal line of credit or credit card to invest?
I will say don’t do it.
Usually the personal line of credit is sitting at 8 to 9% interest per year
not to mention credit card rate is at 19.99%.
Which mean you need to find
an 8% return on investment only to break even.
3. Does investment loan affect my home purchase.
It’s a yes and no question. It depends
Any additional loan such as car loan,
credit card debts, line of credit
might reduce your borrowing power in short term.
But in long term,
the investment loan is generating more asset in your bank account,
and produce a consistent income.
And then you have a higher borrowing power
which helps with your home purchase.
4. should I invest in RRSP or investment loan first?
That also depend on a lot of factors,
Your income, your rrsp room,
when do you plan to withdraw the money?
Any other tax implication when you withdraw?
Note that for rrsp is much more flexible,
you can choose to contribute in a lump sum
or do it per month.
And you can stop it at anytime.
Versus for investment loan,
the tax deduction is base on monthly interest payment.
And you cannot stop unless you repay the loan.
One of the spin off idea is.
You can borrow to invest in January,
get the full year interest payment.
When the investment goes well
and withdraw the same amount of money that you invested.
Then reinvested into RRSP.
This way for the same money,
you can do double tax deduction.
But this only applies when you have a decent return on your investment
and you don’t need the money in short term.
Let me know in the comment section if you like the idea of leverage loan
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This is Thomas!
If you want to learn how money works
and how you want to work with money,
then I will see you in the next video!
Bye guys!