After more than a dozen years of rising stock markets, a reader wonders if it’s still a good idea to borrow to invest? You’ll be surprised at the answer
The strategy of leveraging your home equity to invest in ETFs can be an effective tool to build wealth. Photo by Getty Images/iStockphoto files By Julie Cazzin, with Doug Robinson
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Q : I’m a 42-year-old engineer and in the top tax bracket. I would like to leverage my home equity line of credit (HELOC) by investing in dividend-paying exchange-traded funds (ETFs). Is this an effective tax savings strategy, and what are the pros and cons of using such a strategy to build wealth? — Mo
FP Answers: The strategy of borrowing to invest comes with increased risks and does not always end well for investors. But before getting into specifics, it’s important to look at your entire financial situation to see if this strategy would be right for you.
First, you need to determine if it’s worth taking the increased risk of borrowing to invest in order to achieve your financial goals. If you take into account all your assets and savings, are you on track to achieve your goals without taking the additional risks of this strategy?
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You also need to evaluate this strategy in the context of your overall financial plan. And, Mo, while you don’t provide enough financial details here for me to offer guidance either way, generally speaking, the strategy of leveraging your home equity to invest in ETFs can be an effective tool to build wealth.
The main reason is because you are using very little of your money (just the payments on the borrowed funds) and, at the same time, investing a much larger amount (i.e., the amount of the HELOC), which has the effect of giving you the returns of the entire underlying investment.
Essentially, you are magnifying your gains, but be aware you are magnifying losses as well. Borrowing to invest works well when investment markets are rising. But it’s hurt a lot of investors when markets are falling, and deeply hurt their bottom lines.
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You are magnifying your gains, but be aware you are magnifying losses as well
Of course, we don’t have a crystal ball to see into the future. But investors all too often rely on recent experience as their guide and, as a result, leave themselves open to bad outcomes due to excess confidence.
On the plus side, there is good news in regards to taxes. Interest paid to earn investment income is an eligible tax deduction on line 22100 of your tax return. Dividends are considered investment income, so selecting a dividend-paying ETF satisfies this requirement (but capital gains do not).
Remember, for tax purposes, you must keep the debt separate from your other liabilities in order to fully deduct the interest. That means you have to be careful about where you hold the HELOC money, as well as how you use it.
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A key point to note is that you’re not eligible for the tax deduction if you invest the money, say, in your tax-free savings account (TFSA). That’s just one detail you have to abide by. There are many others, so I usually recommend to anyone considering this strategy to seek the advice of a good tax professional.
The objective, of course, is to make money on this strategy, and the profits are taxable if you do. You get immediate tax relief, but you will be paying more taxes overall if the strategy succeeds. Although tax savings can seem appealing and are a consideration, they should not be a key driver in making this decision.
You also asked about the cons of the strategy, so let’s explore a few. Ask yourself: if you borrowed $100,000 and markets fell by 35 per cent, would you be comfortable continuing to make your payments knowing you owe $100,000 and only have $65,000 left in your investment account? Even though markets only fell 35 per cent, your money has to now rise by almost 54 per cent to get back to where you started, which may take several years.
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Will you be committed to the strategy for long enough to earn back the 54 per cent plus the after-tax cost of your interest payments knowing you will only be breaking even at that point?
It’s best if you’re committed to the strategy for a minimum of five years, but capable of carrying it for 10 years or more. Is your job secure enough for you to know you will always have the same income to make the payments? If you become sick or disabled, is your income insured, and will you be capable of remaining committed to the strategy?
Also, if you sell your home, you have to pay off the debt and lose the tax deduction for the interest you are paying. You can keep the investments, but you will now have $100,000 less home equity to purchase your next property in my example. Will this be acceptable to you?
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And let’s not forget about borrowing costs. Many lines of credit have a variable interest rate. Two things happen when rates begin to rise. First, your investments have to earn a higher return to offset the increased cost and, second, you have to have the capacity and willingness to make higher payments in the future. There are clear signals the cost of borrowing will be rising in the future.
As you can see, there is a lot to consider before making your final decision.
Investing in a well-diversified complement of dividend growth ETFs has merit. Companies initiating and growing dividends tend to be high-quality businesses that deliver competitive returns over time.
However, there are many arguments for other types of investments that will improve diversification. I would be comfortable with a dividend-paying ETF as a portion of my portfolio, not the entire portfolio. I would also be looking at other investments to diversify my portfolio before using borrowed funds to build it.
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Generally speaking, it’s good to take full advantage of your registered retirement savings plan (RRSP) and TFSA limits before considering a strategy such as borrowing to invest.
More On This Topic FP Answers: Should I sell my house, invest the money and rent? FP Answers: How do I shelter investment income through a corporation? FP Answers: How should I invest the extra $2,000 a month now that my mortgage is paid off? As well, I like to see investors have stable family incomes and be saving money outside the payments necessary to fund the loan. Finally, it’s extremely important to have experienced volatile and declining investment markets to prove you have the ability to remain invested through a prolonged downturn.
For the past 13 years (or since you were about 29 years old, Mo), markets have been advancing with only a few brief setbacks. The last real test of investor fortitude was in 2008. You may well meet all of these criteria, but I include them to help you decide if borrowing to invest is right for you.
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Article content I would be remiss if I did not comment on timing and share how I use this strategy in my life. It is best to commence this strategy when markets are at low points. However, we have no idea if the markets are high or low until we benefit from hindsight. But we do know we are in a bull (upward-moving) market right now. Likewise, we will know when we are in a bear (downward-moving) market.
In general, I feel much better about entering into a strategy such as this after I can see six to 12 months of a bear market in the rear-view mirror. Mo, you are going to experience many more bull and bear markets in your lifetime. A common driver of entering into this strategy right now is fear of missing out. I am not participating in that. In the past, this strategy has been part of my financial plan, and it probably will be in the future. However, I am not using it right now.
Mo, I wish you happiness and success in your finances and life.
Doug Robinson is a certified financial planner and chief executive of Veritable Wealth Advisory Inc. based in Peterborough, Ont.
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