With interest rates close to 40-year lows, the concept of borrowing to invest is a strategy worth considering in building your long-term wealth. Prudent borrowing, and wise investment of the proceeds, can lead to significant wealth creation over time.
The key is to invest in good quality assets that will stand the test of time. A well-managed, diversified mutual fund avoids the risk of investing in a single business. Borrow only an amount that you can comfortably carry, and that won't cause you anxiety should your investments suffer a temporary decline in value."
Leverage is a powerful tool that cuts both ways. If you borrow to invest, whether you have gains or losses on your holdings, the effects will be magnified.
For example, if you put $100,000 into a mutual fund using $25,000 of your own money and a $75,000 loan and the fund gains or loses 10 per cent or $10,000, that would actually be a 40 per cent gain or loss on your original equity before loan costs.
There are also tax considerations that should be understood by investors contemplating a borrow-to-invest strategy. The Income Tax Act has rules that apply to the tax deductibility of interest, including:
Interest is Tax-Deductible
Typically, you can borrow to invest at the current prime rate, plus one to two percentage points. However, for an investor in the top tax bracket, with deductibility of loan interest costs, the actual cost would be about half.
Remember that only half of any capital gains realized on your portfolio are taxable as income. And even if the value of your investment increases, a taxable capital gain is not actually triggered until the holding is sold or a manager realizes gains within the portfolio. If your mutual fund doesn't pay a taxable distribution, you may deduct annual borrowing costs from your other income.
Generally, the higher the portfolio turnover, and the more tax you pay annually, and the higher the overall return needs to be for you to make money after borrowing. Low turnover means that realized gains are kept to a minimum, and taxable distributions are minimized, allowing more of your capital to work for you."
Important Variables Affecting Returns
There are four key variables that affect your ultimate returns:
Generally, borrowing to invest is considered an aggressive strategy that requires careful evaluation with a financial advisor. An advisor can help you determine the suitability of investments for a borrowing strategy. Investments must be able to generate an after-tax investment return that is greater than the after-tax interest cost.
I would suggest the possibility of restructuring your finances if you currently have non-tax-deductible debt such as a home mortgage or a car loan, while also owning taxable investments such as stocks, bonds or mutual funds. You may be able to pay down your mortgage or car loan, and borrow against your investments instead.
By converting your non-tax-deductible interest expense into tax-deductible
debt, you can reduce your overall borrowing costs.
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