Borrowing To Invest: How To Build Wealth With Dormant Assets

Dividend Earner

Dividend Earner

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7 min read Affiliate Disclosure

At some point, you may think about borrowing to invest, but I am not talking about investing from a margin account. I mean borrow money from a loan, or a line of credit, or execute what is called the Smith Manoeuvre.

The intent is to use dormant assets to make some more money. It might sound counterintuitive, but if you execute it well, you can increase your investment returns and reach your financial goals faster.

Simple, right? The concept is, but the emotional part isn’t …

Borrowing Is Done Every Day

Everyone borrows money. You borrow money when you buy with a credit card, it’s just really short-term.

You have loans when you get a mortgage or a car. Often, whomever is giving you a loan is saying that the collateral is an investment but is it? Is your home an investment? No, it’s an asset with appreciation potential. Is your car an investment? No, it’s a depreciating asset.

Now if you borrow to invest, you do have a real investment. What’s the difference between borrowing to invest and borrowing to buy a car from a mathematical perspective?

With a personal loan, you have monthly payments to cover the capital and interest but with a line of credit, you have the option to only cover the interest payments. In some cases, you can let the interest grow if you can borrow more. That’s where it gets interesting from a leveraged perspective.

How Leverage Investing Works

The concept is very very simple.

  • Borrow money at X% with a home equity line of credit (A HELOC usually has lower rates)
  • Invest the money to make Y% in total return (so not just the dividend)
  • Deduct the interest from your income (as long as your investments are income-producing), and invest it back. Of course, it’s just like your RRSP tax refund.

You do not have to cover the interest with dividends. That’s the first place everyone goes but you can let the interest compound like your investment compounds.

The second part some miss is to not put the tax deduction back to work. It’s similar to your RRSP deduction, you need to put it back to work! It’s part of your return, and you need to put it to work but you cannot add it to the same investment pool from the HELOC strategy.

Type of Loan

A margin loan is not the same as a long-term loan. The way I see a margin loan is like an overdraft option on your bank account from your beloved financial institution.

The way the bank can ask for its money back with a margin call isn’t something you want to be exposed to for long-term wealth building.

Accounting Details

One aspect of this strategy to be careful about is the accounting details. The Canada Revenue Agency (CRA) will possibly audit you and you need a clean accounting trail as it’s on you to defend your case.

You need a good paper trail between the flow of money from your HELOC to your investment account. Your investment account should be dedicated to this strategy.

The paperwork is key here in case the CRA comes knocking! To have an excellent paper trail, you want to get set up with a different discount broker than your normal one unless you have not used your unregistered account, and you want to show the cash flow between the LOC and the investment account cleanly. The setup is important here.

Monitoring Your Results

This is slightly different from your accounting details. It’s the aggregate view of data over time showing your profit (or losses). It’s your financial compass saying you keep going or you stop the bleeding.

You want to compare the value of your investment against your borrowing cost inclusive of your tax benefits.

Be Clear What Your Investment Strategy Is

The most important aspect of the strategy is to ensure you have a goal and that your goal doesn’t put your overall finances at risk when you leverage your finances.

Clearly state your primary goal so that you don’t lose focus on why you are applying a leveraged strategy. Make sure it’s realistic as well. Doubling your money takes years, for example, so it’s not a get-rich-quick strategy here.

In my case, the goal is to make some money slowly with my dormant asset (ie the house). My annual rate of return is slightly over 10% which is higher than the interest rate I pay (7% when starting) before the tax deduction (50% of the interest). So you must have income to deduct, otherwise, you lose some of the benefits.

Start Early With An RRSP Loan

An introduction to borrowing to invest often starts with an RRSP loan. You might not have the cash on hand to maximize your registered retirement savings plan (RRSP), but you can get a loan to make the contribution and pay it back with your tax refund.

The result is that you get to invest money you otherwise could not have invested.

Understand Your Stock Investing Tolerance

I was going to use risk tolerance, but the reality is that stock is risky in and of itself as it fluctuates daily. There is no such thing as a stock that doesn’t stress an investor.

If seeing your investment down or in the red prevents you from sleeping at night, you can stop reading; this strategy is not for you.

If it was a sure thing, like when interest rates are near 0% and you get a yield of 4% with Bell for example, you have a minimal risk with a 4% return but then as interest rate went up, BCE went down a bit. If you went with a stock like Dollarama, you would do better but then the small yield doesn’t guarantee beating the interest rate, and that’s a challenge for many since you borrow money.

It’s not about the dividend yield vs the interest rate, it’s about total return vs interest rate after deduction. The challenge is that the dividend yield is there and tangible whereas the total return is not and you have to speculate what it will be. That’s a hard thing to do.

Forecasting Your Potential Returns

That’s a very hard thing to do. I am not going to pretend I know a formula. I don’t. Investing is a three-part system

  • The System: reviewing company data as it pertains to their sector and industry
  • The Insight: considering the business qualities and market opportunities. Take Tesla as an example, do you know what insight to have? Even if you don’t choose to invest, you should be able to capture that.
  • The Luck Factor: as much as you want to rely on your other skills, no one controls the market so there is a bit of luck that plays a role.

When it comes to narrowing down investment options, I have relied heavily on 10-10 stocks, or what I call Dividend Ambassadors, to deliver excellent total returns. On the TSX, there are just around 20 of them. Some are slowing ambassadors, whereas others are consistent and look a bit deeper into the businesses.

Experience comes into play as well since you start seeing patterns of some companies and you get to know them and be comfortable with their ups and downs. If you cannot have conviction in your stock pick, then borrowing to invest isn’t for you. Beginner investors have not made or learned from their mistakes yet, so borrowing to invest to learn from mistakes can be expensive.