I have been toying with this idea for the past 6 months. The reason why I haven’t made a move yet is that I was too busy managing debts and moving into my new house. Now that I am settled, I am again looking at the low borrowing rates and the high dividend yields paid by good companies and am asking myself; “Is it too good to be true?”.
I live in Canada and I currently have the possibility to borrow money below the prime rate (I enjoy a discount since I work for a bank). Therefore, my borrowing cost to invest would be 1.50%. About 2 years ago, I was using my Home Equity Line of Credit (HELOC) to invest in the market. I had stopped my strategy, ill-timed in (May 2009) but it wasn’t related to what was going on in the stock markets. In fact, I stopped leveraging since my wife quit her job and was staying home to take care of our two children. With only one income in our household, I thought of reducing our investment risk. But now that we are financially stable and that interest rates are very low, I am thinking of leveraging on the investment opportunities that I see.
As of now, I really like the US market in terms of dividend investing. I have recently reviewed a US DIvidend Portfolio and the average rate of this portfolio was 3.74%. So if I borrow money at 1.50% (tax deductible), I could earn a 3.74% yield + potential capital gains. Even if the interest rate rises, I will still be in a comfortable position for quite a while. This makes the investment strategy very attractive.
Cons of borrowing money to invest
There are a couple of things that make me think twice before going ahead with a leveraged dividend portfolio:
#1 The bank may call my line of credit at anytime. While it hasn’t been done in Canada, I have been aware that US banks limited their clients credit facilities back in 2008. This would force me to sell my stocks to pay back my line of credit.
#2 Lack of liquidity. The problem while investing with a loan is that you are stuck with your stocks for a while when the market drops. If you need money for something else, you don’t have many options since cashing your investments will not even fully pay back the loan.
#3 Less dividends to reinvest. One of the keys to a strong dividend strategy is to use dividend reinvesting. The problem when you combine it with a leveraging strategy is that you can’t reinvest the full 3.74% in your portfolio as you have to allocate a part of the earnings to pay interest costs. This will definitely slow down the growth of my portfolio.
Considering borrowing to invest anyways
After giving some it serious consideration, I still think that buying dividend paying stocks would be the best strategy if I was going to take a loan to invest. The steady dividend payout would pay the interest and the investment strategy would become “free cash flow”. Since I am not planning on using this money for a long time, I think this will be a great avenue.
Do you leverage?
Have you ever borrowed to invest in the stock market? What do you think of this strategy? Do you think it’s foolish to invest with other’s people money?
You could (mostly) address your 1st issue by using a term loan rather than a line of credit. If you use a 5 year mortgage rather than a HELOC, you’ll generally pay a lower interest rate and you’ll have certainty that your line won’t be called for the 5 year term. This is a good way to go for another reason — if you’re not committed to your leveraged investing program for 5 years at the very minimum, you should no be doing it. The longer your time horizon, the safer leveraged investing is. You need to be financially and mentally able to ride out a multiyear downdraft.
That being said, money is free right now. Seems a shame to waste the offer. As long as you can handle the added volatility that leverage brings to your portfolio, I think a reasonably limited program of leveraged investing into high quality dividend paying equity is an excellent strategy.
If you use a 5 year mortgage rather than a HELOC, will the interest still be tax deductible? I’m not sure.
Anyone can answer this?
It is a risk… but all things are.
I borrowed $10000 and bought some dividend paying stocks. This month I sold out everything to pay back the loan (I am just waiting for the CAD to USD dollar to be more in my favor before withdrawing the funds from Questrade)
I was blessed to have made 10% but I hated the idea of my stocks dropping and needing to pay back the loan. If you do a poker analysis, it is easy to say that risking $10000 for $1000 is a poor bet.
First of all, I think it’s always important to specify whether the investment in question is in a registered (i.e RRSP) or non-registered account.
If it’s a registered account, my opinion would (almost) always be to borrow enough to make up any shortfall in your RRSP contribution(s), using the tax savings to pay back the investment loan or your mortgage, whichever has the higher % rate. This will drag on your returns but will also amount to forced saving if you’re behind in your RRSP contributions.
If it’s a non-registered account, then I think it’s a good idea as long as:
1) the interest rate is below a reasonably accepted dividend payout rate. Let’s say 3%;
2) it’s not an overburden to re-pay it if you had to, perhaps selling some profit to repay (assuming there’s profit!). For most people, this amount would be 20k or less;
3) you invest only in Canadian dividend payers since you gain the dividend tax credit, thereby reducing the impact on your gross salary. I think the US stocks considered here would be ill-advised as there are always currency fluctuations that can spoil your returns;
4) if it’s for a non-registered account, in most cases, the interest rates you pay can be claimed as tax credit on your Canadian return, further offsetting your borrowing costs.
Always do your due diligence!
Interesting post… you have me thinking about it!
Really though, I don’t borrow to invest for the reasons you outlined above, plus, I already have enough debt: a mortgage. Why take on more? I like to keep things simple.
If you have the stomach for leveraged investing, go for it. Money is very cheap right now. It’s not for everyone though, including me.
I’ve borrowed to invest Mike. Back in May of 2010 I wired the first 5k at prime-0.25.
My official outstanding HELOC balance is 18.5k but my portfolio has hit 35k at some times! Obviously, since my dividend payers have already been chosen, i am using them as margin to invest in and out of non dividend payers. So far so good, +40%.
By the end of November only the dividend payers will be left since my low commission promotion will be done by then.
@Matt,
I’d say that a variable rate mortgage would probably the cheapest way to borrow. I agree with you; 5 years is a bare minimum for leveraging.
@12 minute,
As long as you can create a seperate account and show that you have borrowed with the reasonable expectation of making profit, you are good to deduct your interest.
@Dd,
Have you considered waiting and earning your 4% dividend yield + capital gains over several years? Then your poker analysis would make more sense 😉
@Peter,
good point of bringing the type of accounts; it’s very important when leveraging! However I disagree with you with borrowing your unused RRSP contribution. You are better off using your free cash flow to invest on a monthly basis instead of using it to pay a loan with non-deductible interest.
oh, and thx for your comments guys!
Hi Mike,
I definitely agree that it is a good time to borrow to invest. I’m thinking of starting shortly, but am waiting for a market pullback to start up. As I don’t have access to a HELOC (yet), I’ll be taking advantage of the good ol’ margin account.
In terms of US vs. Canadian dividends, from a tax perspective, I think that Canadian stocks are far superior as then you get to keep all of the dividends + some of the interest rate spread (as the tax deduction on the loan is at your marginal rate while dividends are taxed less). For US stocks, dividends are taxed at the marginal rate which decreases the returns slightly. Also don’t forget about the withholding tax. If it’s not in an RRSP, subtract an additional 15% from any US dividends received.
All in all, I figure if you have a non-callable loan (or HELOC) and can cover the interest payments with the dividends received so there’s no impact on your free cash flow, so long as you selectively invest leveraging is a great long term strategy with rates this low.
I did this. If it is good terms and I can invest at a decent spread I would borrow all day long. But you can not always find a ‘safe’ investment that pays enough to make it worthwhile.
I took advantage of 0% for 9 months with a $400USD fee. Depending on the amount you borrow, amoritize the fee and it is still cheap money. I invested it in preferred shares selling at a discount to par and in some riskier high yield REIT stock. I am able to make extra payment on the loan and at the end of the term I will get to keep much of my positions. I would do it again except there are no longer any current investing opportunities that meet my strict margin of safety rules. Maybe at the end of the next crash. Yes another one is coming.
Leverage works great – both ways! [See: Lehman Brothers, 1850-2008, RIP] The stock markets are filled with really smart people who do this full time. Before you try to outsmart the system ask yourself if you think you can beat guys like Buffet, or even some CEO of a Value company paying big dividends – who is dumping his own shares.
You do not say what level of leverage you are considering, but even
100% will double your losses if we have another market break like in 2007-9. [See also: 1930s] Did you sit comfortably through the recent Bear Market without selling [or wanting to sell] equities? How will you feel if the next time your losses are multiplied 2X, or nX?
Leverage is hard to control. In a declining market another way to look at things is that when NAV goes down your leverage goes up.
Anyone even thinking about using leverage should read a few [more] books on stock market and speculation history. I just finished reading Edward Chancellor’s Devil Take The Hindmost, which is really excellent – and sobering.
Never put any money in stocks that you can not afford to lose, and IMHO never use leverage in the stock market!
Good luck and best wishes to you.
I am thinking to get 5 year 3.19% mortgage from my house. And invest in 3.5% 5 year GIC. So there is no risk at all. Am I correct ? Assuming the cost of mortgage can be deducted. Make sense?