My finances reached the point where the house represents a lot of dormant cash, and it’s a dormant asset not generating any income so I thought I could put it to work.
In the real estate world, you use equity in one place to buy the next one. It’s called leveraged and it’s done all the time. It’s also a concept investors use with investments.
Borrowing to invest is the same concept.
- A real estate investor borrows cash from one property to buy the next one and it usually starts with the primary residence footing the first down payment in the form of a loan.
- An investor can borrow to invest and borrowing is done based on your ability to borrow and provide collateral which is usually your home.
The tactical part is also the same now that the concept is clear. There is a loan and interest needs to be paid on the loan. There are two options here:
- Pay the interest monthly from the income you receive.
- Let the interest compound through self-capitalization.
The second point is rarely done with real estate but often executed with the Smith Manoeuvre.
The Approach Taken
Here is the setup.
- A new HELOC with TD setup against the home with the interest at prime + 0.20%.
- A new investment account with TD was set up to separate the transactions from everything else in my portfolio.
- A new bank account with TD to flow the money in and out of the HELOC for interest payment capitalization.
The CRA will probably audit down the line, so having a clear paper trail is critical. The new accounts at a new institution allow me to have a very clean paper trail.
The idea is that the interest paid is tax deductible so you must do this when you have an income. If you don’t have an income, you cannot deduct the interest paid. The interest paid is also only deductible if you invest in income-producing stocks or products that pay an income.
Unlike what many assume, I am not paying the interest from the dividend income. As such, I do not need to have dividends that cover the interest payments. I am paying the interest by borrowing more every month. So the interest is compounding but so are my investments.
The idea is to make more than the interest paid. The interest rate is fixed so we know that. While an investor could choose an investment with a known yield to feel comfortable, I am not approaching it this way. I am approaching it with an angle that my stock picks will outperform the interest rate I pay minus the tax deduction (my marginal tax rate is high).
The Two Interest Strategies
There are two thoughts on borrowing to invest. I have done both now.
The Interest Is Covered By The Dividends
I borrowed to invest over 10 years ago and I approached it with the idea that the dividends should cover the interest rates. That was the obvious model to me and the obvious one for many.
This concept is simple, you borrow $10,000 for example at 2% and you find a dividend investment with say 4% yield to cover the interest. The challenge is that the interest is monthly and the dividend is quarterly so you do need a way to cover it during the first quarter.
This model is easy for anyone to understand and see the benefits.
The Interest Is Covered By The HELOC
This approach compounds the interest. It means that every month you borrow more from your HELOC to pay the interest. It’s also known as capitalizing the interest.
The Investment Strategy
The approach used here is to capitalize the interest and let it accumulate. That means the interest is growing every month and the cost of borrowing also grows
The investment must be able to outperform the capitalized interest. It’s not about the dividend yield being greater than the interest. I do understand this is a lot harder for many to comprehend and execute. The first time I borrowed to invest, I used the obvious method but now I am more experienced and I can select stocks based on total returns.
When focusing on total return with a dividend (remember that it needs to create an income for the tax deduction), the yield will be lower than the usual income dividend stocks with less appreciation.
Levered Portfolio Details
- Market Value: $41,457
- Profit: $908 (plus tax deduction from interest)
- Total Borrowed: $40,000
- Total Interest: $549
- Total HELOC: $40,549
- The interest rate from HELOC: TD Prime + 0.20%
A Word On Risk
Investing with borrowed money is risky. You could lose a lot of money and then you are left with a loan but it also depends on how much you borrow. Don’t borrow more than you are comfortable with.
Take a car loan for example. Say you have a loan on a car and then your car breaks down and stops working. You have no car and a loan left to pay. You even have to spend more to fix it. The funny thing is that most people don’t second guess a car loan because the risk of the car breaking down that way is small and there are warranties on a new car providing you with safety concerning your loan. But you do make a risk vs reward decision based on your understanding of all the factors.
Borrowing to invest is the same. Stocks are a way for a company to borrow money to invest. It’s doing so to allow you to make money. It’s the principal of the stock market. When I invest, I do so with an understanding of the investment under normal conditions.
Worrying about recession, wars, or disasters, in my view, is not having control over where you are going but always focusing on where you don’t want to go. It’s the difference between playing an offensive game vs a defensive game. Playing defence is playing not to lose instead of playing to win.