Clients must understand the implications when borrowing to investBy Rosemary McCracken | January 24 2012 09:28PM
Loans are part of life for many Canadians. We take them out to pay for our cars, our vacations and our homes. But taking on debt in order to build personal wealth is usually considered a strategy only for sophisticated investors. However, Paul Stadnik, Toronto-based vice president, banking products, at Mackenzie Financial Corp., believes it will become more mainstream in coming years as a strategy to build assets outside registered retirement savings plans.
“Canadians are very comfortable about taking out a mortgage to buy a home,” he said, “but they’re not as comfortable with borrowing to purchase other investments. “But if an investor can contribute, say, $500 a month to an RRSP, why not split that and put $300 into the RRSP and use the remaining $200 to carry an investment loan?” he asked. “Down the road, that investor will have two pots of wealth, one in registered investments and another in non-registered investments.”
Borrowing money to invest is a strategy that financial advisors may consider employing as a way to grow a client’s financial assets, but the client will need to understand all the implications of making use of somebody else’s capital.
Where to borrow to invest
Most financial institutions offer loans to invest in RRSPs, typically at the prime interest rate. Unlike borrowing for non-registered investments, the costs of RRSP loans are not tax-deductible, but the tax-free growth of the assets in the RRSP should help offset the interest on the loan. And the income tax refund can also be used to pay off the loan.
Banks also lend money to purchase non-registered investments, but they will often steer investors into taking out home equity lines of credit, which means putting up their homes as collateral for the loan.
Mr. Stadnik recommends advisors go through a niche lender, such as B2B Trust, AGF Trust and Manulife Bank that deal directly with the advisor channel and specialize in mutual/segregated fund lending.
Investors can also borrow through brokerage firms or discount brokers. This is called buying on margin, and clients are typically allowed to borrow up to 50% of their investments on margin. Wally Jaciuk, BMO Bank of Montreal’s Edmonton-based director of investment sales, prairies division, said borrowing to invest can be particularly useful for a client who is facing a shortfall in retirement income. Taking out a loan to purchase investment products not only enables him to acquire more assets, but is also a forced savings plan. “He is now obliged to be disciplined about paying back the loan because it is a contractual agreement,” Mr. Jaciuk said, “although he wouldn’t have needed it if he’d been making regular contributions all along.”
But before this strategy is employed, he said the advisor needs to determine the client’s retirement goals. “Where does he want to live? How does he want to spend his time, and with whom? How does his health look going into retirement? And what kind of appetite does he have for investment risk? The answers to these questions will determine whether your client is facing a retirement income gap, whether an investment loan is necessary, and if it is, how large it needs to be.”
Significant costs and risks
Borrowing money to invest, Mr. Jaciuk maintains, cannot be entered into lightly. From the outset, there are significant costs attached to using someone else’s capital. And there are significant risks, which the client needs to understand. “While leveraged investing can magnify gains,” he said, “it also magnifies losses. If you lose, you can lose big.”
The interest rate the client pays on his investment loan will cut into his investment profit. This means he should expect to earn a higher rate of return than the rate of interest he’s paying on the loan, but there’s always a chance that the investment won’t do as well as expected. And that it will go down in value. If it does, the investor will still need to pay back the full amount he borrowed, as well as interest charges.
A tax break, however, is available to those who borrow to purchase unregistered investments that earn interest or dividends. The interest on the loan can be claimed on the investor’s tax return, and will help defray the cost of servicing the loan.
If interest rates go up, it may cost your client more than he counted on to service his debt. Investors who put up their homes or other assets as collateral behind lines of credit also need to be aware that these assets are at risk should the value of the investment decrease substantially. Those who buy on margin may be required to put more money into their accounts to cover losses. They’ll need to have a back-up plan in case they encounter this problem.
And investors who lose their jobs or suffer other financial setbacks may find it very difficult to pay off their debt.
There are simply no guarantees in the investment world, which is why Mr. Stadnik recommends having your client borrow far less than the full amount the lender determines he could carry.
Leveraged investing, he added, is for clients who have a financial cushion to handle losses if markets correct. They also need the psychological makeup to ride out market corrections. “Investors with low risk tolerance may panic and sell prematurely. To take advantage of markets’ long term performance, they should be able to stay invested for a minimum of 10 years.”
But the client’s age or financial wealth needn’t be a factor. “Leveraged investing isn’t just for those with six- and seven-figure salaries,” Mr. Stadnik said. “And I love to see a 28-year-old borrowing $10,000 or $15,000 for investments outside his or her RRSP.”
If carried out responsibly, leveraged investing can help build an unregistered investment stream. As the investment loan is paid off, the investor’s equity increases and eventually he will own the assets outright. And no limitations are placed on amounts invested outside registered plans.
The client’s unregistered investments, Mr. Stadnik noted, will receive favourable tax treatment upon redemption. “While RRSP gains are taxed as income when they are removed from the plan, money earned outside a registered plan is taxed at a much lower rate as capital gains. If an investment grew by $10,000, the investor would be taxed on $5,000 of that amount.”
The earlier a client gets into this mindset, the better, he said. “For young people, time is their greatest asset because compounded returns quickly add up. By borrowing money to purchase investments, the young client is not only able to invest a larger amount, but he’s also putting time and the principle of compounding to work immediately.
“If I’d taken out a $10,000 investment loan in my 20s and was able to carry the small amount of interest on it,” he added, “I’d be retired today.”