Should you open a margin account with your broker, or opt for an RRSP loan? Read about the potential tax benefits and risks.
There are a few different ways to borrow to invest.
A simple option to borrow to invest is by using a margin account at a brokerage. Depending on the existing investments in the account, a brokerage will lend up to a certain percentage of the value to an Canadian investor, at a specified interest rate.
You can have access to an amount of “maintenance excess,” which means that money needs to be kept in the account as collateral for borrowed securities. It generally ranges from 30% to 100% of the market value. Larger, established, blue-chip stocks may only have a 30% margin requirement, meaning up to $70 can be borrowed for every $100 invested.
Margin interest rates generally range from 7% to 10% but can vary. The interest is tax-deductible when the borrowed money is being used to invest but not if it is withdrawn and used for non-investment purposes. If stocks fall, in Canada, a margin account investor could have a “margin call” and need to deposit more funds or have to sell stocks to reduce leverage.
Investment loans with required monthly principal and interest payments are another option for borrowing to invest. Registered retirement savings plan (RRSP) loans are often at competitive interest rates as low as prime. Non-RRSP investment loans may be at prime plus 1% or more. Interest rates are reasonably competitive because some financial institutions are getting paid twice on the same transaction, earning interest on the loan and generating fees on the investments purchased.
An investment loan may generate tax deductions, but only for the interest portion of the payments, not the full principal and interest payments. Interest on money borrowed to invest in an RRSP or a tax-free savings account (TFSA) is not tax-deductible, however, because the income being earned is not taxable income. Interest paid to earn taxable non-registered investment income (such as outside of a registered account) is tax-deductible.
Lines of credit or mortgages on real estate can be used to invest, and the interest can be tax-deductible as well. An important distinction is that it is the use of borrowed funds that determines tax deductibility. Borrowing money against a rental property does not make the interest automatically tax-deductible if the funds are used for a personal purpose. Borrowing money to invest—whether it’s in stocks, bonds, mutual funds, exchange-traded funds (ETFs), a rental property or a business—is a common criteria for interest deductibility.
Interest for funds used to finance an income property can be deducted on your tax return, including money borrowed against a personal-use property, like a home or cottage, if the funds are used towards a down payment, renovation or other costs for a rental property that earns rental income.
Borrowing to invest can enable an investor to amplify their returns by leveraging their capital invested. But is borrowing worthwhile?
You can come up with different results to support or oppose borrowing to invest, depending upon the time period you pick. But if we go way back to 1935, the long-term average prime lending rate in Canada has been about 7%. Canadian stocks as represented by the TSX have returned 9.5% per year. The S&P 500 in the U.S. has generated about an 11.4% annualized return including reinvested dividends. All figures are as of December 31, 2022.
At first glance, borrowing to invest in stocks seems to make sense. But most Canadian investors would not invest 100% into stocks. Adding in bonds and other fixed income could reduce returns. Deducting investment fees and transaction costs would reduce returns. Introducing potential bad investor or advisor behaviour, like buying high or selling low, could also limit the net benefit.
Real estate is a much more difficult asset class to identify historical returns. This is in large part because the return is based not just on price appreciation, but also net rental income. Rents are not tracked the same way historical dividends are for stocks.
Real estate may be a better investment to borrow to invest in than stocks, bonds, mutual funds and ETFs. There are a few reasons for this. One of the main ones is that real estate is less liquid. If stocks fall, you can panic and sell with the push of a button. Selling real estate requires a lot more work and that can be a deterrent from knee-jerk reactions.
Real estate is also less volatile. Stocks fall roughly three years out of every 10 years, whereas real estate generally appreciates in value. As such, it can be a more stable asset class.
Finally, rents generally reflect the cost of ownership plus a profit for the landlord due to supply and demand, and the income appreciates over time, tracking reasonably well with inflation. There can be significant differences in the rent to market value ratios in different cities, with some areas in Canada right now relying much more on capital appreciation than income. Low rents and high market values should be a red flag for local investors, but the economics of owning a rental property are generally well suited to leveraging a purchase with debt, regional anomalies aside.
Borrowing to invest may increase returns if you time things right, but market timing may be as much luck as it is skill. Leveraged investing, whatever the investment purchased, is best done over the long run as opposed to for short-term gain by investors with a high risk tolerance. Market efficiencies have a way of punishing the average short-term investor and rewarding long-term investors in the process.
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