If you thought interest rates couldn’t get any lower, you’d be wrong (for the record – I was one of them). With the Bank of Canada cutting the overnight lending rate for the second time this year, it looks like the low interest rate environment is here to stay for the foreseeable future. So one might ask – how low are today’s five year fixed mortgage rates historically? The chart below shows more of the history of the five year bond which impacts the five year fixed mortgage pricing. The answer – if you were looking to time the interest rate markets … is that now looks pretty good! Your upside to waiting for rates to fall further just does not exist!
With rates so low, you may be wondering what to do with your money: should you pay down debt or invest? Conventional wisdom says you should pay down debt, as it provides you with a guaranteed rate of return. While that may be a good strategy for risk-adverse individuals, for high income people looking to grow their net worth over the long-term, there’s never been a better time to borrow to invest. If you’ve built up substantial home equity, why not tap into it and use it to your advantage get OPM (Other People’s Money). After all this has been a time tested trick that the wealthy have used for over a century now.
Why borrowing to invest makes sense
There are a lot of misconceptions out there about borrowing to invest. While borrowing to invest can magnify your losses, it can also amplify your gains. When borrowing to invest is done right (buying conservative investments where you don’t jeopardize your household cash flow budget), it can help build your net worth that much faster. Borrowing to invest is a form of leverage, and a key way that the rich get richer. The most successful businesspeople like Donald Trump borrow to invest. If the strategy is good enough for Donald Trump, why wouldn’t you consider this strategy yourself? We borrow money to buy depreciating assets like cars, electronics and appliances, but for some strange reason we’re hesitant to use the same strategy for assets that can increase our net worth. Something doesn’t add up.
CALUM ROSS VERY KEY NOTE: Please remember that conservative and well planned is the name of the game. If you don’t have the cash flow or stomach to deal with shocking headlines about: “WHY COMPANIES WILL NEVER MAKE MONEY AGAIN AND STOCKS WILL ONLY LOSE VALUE“, or, “WHY PEOPLE OF THE FUTURE WON’T NEED HOMES TO LIVE IN AND HOW REAL ESTATE WILL CRASH IN THE NEXT TWO HOURS” then stick with Canada Savings Bonds (where you return will be less than the real rate of inflation (thus you will get poorer every year)… but at least on a patriotic note – you will at least be allowing our country to spend more money than it can afford to spend and be funding our overspending public sector :).
Borrowing to invest is only as risky as the investments you’re holding. If you’re planning to tap into the equity in your home to invest in penny stocks or trade futures contracts, then borrowing to invest is a very risky strategy and I would advise against it. However, if you’re investing in diversified portfolio of top quality stocks, positive cash flowing real estate, or index based funds and only borrowing a modest amount that you can afford to make payments on even if rates go up, you can greatly reduce that risk. The key is that you need to have a steady hand. I repeat … if you have a urge to sell the moment the markets take a swing the other way, borrowing to invest isn’t for you. To protect myself from myself I personally only look at my investment holdings once every three months. With real estate I intend to hold or RRSP money I simply consider it like monopoly money… unless I am cashing in my chips the value does not matter.
When you borrow to invest your loan interest is tax deductible. As an incentive to invest in the economy, the government lets us write off interest when you borrow to invest in a non-registered account (sorry, an RRSP and TFSA loans don’t qualify). The higher your marginal tax rate, the more sense it makes to borrow to invest.
To help better understand the power of borrowing to invest, we’ll run through an example. We’ll use the top combined federal and Ontario tax rate (for simplicity’s sake, we’ve rounded the combined tax rate up to 50%). At a 50% tax rate interest cost is 50% less. To put this in perspective, a 2.10% mortgage variable rate mortgage (prime less 0.6%) becomes only 1.05% after interest deduction (50% cheaper). As an investor, as long as you’re able to earn an after tax return greater than 1.05% you come out ahead. With the TSX expected to have an annual return of 8% to 9% over the next decade, hopefully borrowing to invest seems like a safer strategy. If you’re interested in borrowing to invest, contact our offices today and we’ll walk you through the process.