Dear Nancy Woods,
With borrowing interest rates so low, I'm thinking about getting a loan or line of credit and using the money to invest. I am a 30-year-old single man without a spouse or dependents. I am just starting my career as a lawyer, and I rent the condo I am living in. I know it's important to start saving and investing as soon as I can. What do you suggest? Is this a good strategy?
The strategy you are contemplating is what is called "leveraged investing." You are borrowing to invest, with the expectation that your return will meaningfully exceed your cost of borrowing. There are pros and cons to this strategy. The pro is that you are using borrowed funds to hopefully accelerate your wealth building. You are correct in saying that in a low interest rate environment you can find investments that pay a higher rate of dividends and/or interest than the interest rate you are being charged by the lender. Many securities don't provide an income stream, and you would buy them for the potential capital appreciation (capital gain) they may offer. You benefit from the difference. Also, you can deduct from your income the interest charged for investing in a non-registered account. While this particular tax benefit isn't available for topping up your RSP or TFSA, you still may enjoy other tax relief by contributing to these plans.
The strategy does have several risks as well. Some investments don't perform as expected, and their price goes down significantly. Others risks include an investment cutting or reducing its dividend. You also have to consider the rate of tax you will pay on any income and capital gains. One of the strategy's most dangerous risks is a margin call, where you are required to sell securities or add cash to a brokerage account if you are using your portfolio as collateral. Lastly, with any leverage strategy, there needs to be a plan to pay back your lender.
The major consideration you have to review is your overall financial position and your timeframe. If you have a lot of other payments and have very little left over each month, or you have other debts, it does not make sense for you to take on more. Leverage investing is not a "get rich quick" strategy. Nor is there any guarantee it will work in the short term or at all. You have to be very knowledgeable when using borrowed funds to invest and what you are investing in. Nothing is a sure thing. If you choose to implement this strategy, be sure you work with a professional who has your best interests at heart, and will appropriately advise you and frequently monitor your overall investment and borrowing plan.
Nancy Woods is an associate portfolio manager and investment adviser with RBC Dominion Securities Inc. Visit her website www.nancywoods.com or send an email request to firstname.lastname@example.org. You can also send your questions to email@example.com.