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Borrowing money to play the stock markets has been a long-time practice for experienced investors, but for Canadians who hope to reap big financial rewards it's a risky proposition that could wind up costing them their home.
One of the easiest ways for the average person to obtain a large chunk of cash for investments is by taking out a secured line of credit. A home equity loan can provide a significant amount of funds to invest — a practice commonly known as leveraging — but inexperienced investors could quickly get themselves in too deep.
The loan, ideally, should not only cover the cost of the investment but also any costs like fees and interest payments on the money borrowed.
"This is definitely not a strategy for individuals that do not have some degree of appetite for debt," said Andrew Pyle, a senior wealth adviser at ScotiaMacLeod in Peterborough. "And it's not for the majority, I would put it that way."
As an investor you should first ask yourself, if all of the money I put into the stock markets were to evaporate, how would it affect my overall living standards and life plans? If the answer could throw your life into uncertainty, then it's not a smart investment plan.
And if taking out a line of credit is your only option to play on the stock markets, then you should probably reconsider.
"The outcome of stocks is a completely random event," said Pyle.
"We've seen massive corrections in the stock market in the last decade, and if I was borrowing to fund a portfolio of stocks and that happened, I could run into some significant trouble."
The Ontario Securities Commission suggests that investors consider several factors before they take on a notable level of debt. The list includes:
- Are you comfortable going into debt for an investment that could fluctuate in value?
- What fees do you have to pay to buy, hold and sell the investments?
- What are the tax consequences? While interest paid on the borrowed money might be deductible, any profits booked could be taxed.
Also consider whether an unexpectedly steep interest rate increase would throw you into a situation in which you would miss payments.
"Most investors forget about the other side of the coin — the really dark side," said Adrian Mastracci, the portfolio manager of KCM Wealth Management in Vancouver.
"Always ask yourself, 'What if this thing goes sour? How am I going to get myself out of this?"'
Consider this situation, a retired couple has paid off their home and decides they can afford to play the stock markets by taking out a new mortgage of $100,000 at an interest rate of five per cent.
Their plan is to invest in a mutual fund under which they'd need to get a minimum of five per cent back to meet their mortgage payments.
But throw in the especially unpredictable state of the economy, and the mutual fund could lose some value over time. Those factors could put the couple into a financial lock if they are unable to meet the payments.
Since the couple's home was their only major asset, they're strapped for alternatives, so they must sell the investments at a loss simply to meet the payments, or sell their home in hopes they will recoup enough to pay off the mortgage.
A safer approach would be to invest small amounts of money, rather than a huge chunk. Start with $5,000 to $20,000, Mastracci suggests.
"It's something you could deal with a lot better," he said.
"Borrow that, make your investment, and then pay off your loan."
Play it safe when you can't afford to be a high-risk investor, and it will save you more pain in the long run. While investing rewards those who are willing to take risks, it's hardly worth putting your comfortable future on the line in hopes of striking it rich.