 You are considering borrowing to invest, or you may have already done so. In this, the second in a three part series on borrowing for investment purposes, we have put together some practical tips. We list the things that a prudent investor should consider doing (or not doing) when borrowing to invest.
Do you have the profile?
In our first commentary, we discussed the profile of the ideal borrower:
- Considerable investment experience (and have experienced one or more complete stock market cycles)
- A high tolerance to risk
- A stable source(s) of income;
- A sizeable cash flow.
These characteristics enable them to borrow long term at favorable terms and conditions, and to easily absorb both the financing costs and difficult markets, and in particular to borrow and invest for the long term.
Excluding finance experts (a rarity, especially these days), only investors with such an ideal profile should even consider the possibility of borrowing for investment purposes. Are you in this category of investor? If you're not, but you nevertheless decide to borrow (not our recommendation), proceed slowly, gradually borrowing small amounts, giving yourself the chance back out without too much damage.
How much to borrow?
If you borrow using your margin account with your broker, the borrowing
limits are set by the standards of
the IIROC;
see section 100
of the
IIROC
rules.
These standards apply to both discount and full service brokers. They may vary over time and are based on the amount and nature of the investments in your account.
For example, if you have $ 100,000 in of Canada
treasury notes in your account, you could borrow nearly an equivalent dollar amount and buy shares (this is a simplified calculation; in fact, you could borrow more since the shares purchased and now in your account themselves increase the borrowing capacity of the account).
If the value of your investments goes down, you will need to inject more money or other assets into the account to remain in compliance with these requirements. And if, to take an extreme case, your investments fall significantly and you
fail to put more money or other assets, the broker could sell, as necessary, all or part of your investments to correct the situation; see Your Broker’s Margin Account Form
.And if this were not enough, he retains the right to take legal action against you to recover any deficit.
And if you decide to deal with a lending institution, the standards may, again, let you borrow a large amount of money. If you borrow by giving a mortgage on your house, the amount you can borrow in Canada is typically calculated by calculating your monthly interest payments as a percentage of your income. In general, see CMHC 2009
doc.1259E
If you take out a personal loan not secured by mortgage, for example under a line of credit, the maximum amount is subject to other applicable limits of the lending institution. These will also be based primarily on your annual income, but since the loan is not secured by a mortgage, the amount allowed is typically less than for a mortgage loan.
Like a margin loan, lending institutions often allow you to borrow large amounts, and if, to take an extreme case, your investments fall significantly and you fail to make your monthly payments, you are once again at risk on your investments and on your other assets.
Our conclusion: Do not use the lending standards of brokers or lending institutions to decide whether and how much to borrow. These standards allow you to borrow very large amounts, and to put at risk your portfolio, if not your other assets, even your home. Do not rely on the fact that these rules allow you to borrow a particular amount of money: it does not mean that the amount is not excessive for someone in your particular situation.
A more stringent limit
If you do not have the profile of the ideal borrower (see above), your
borrowing plan may be more akin
to speculation, an approach outside the parameters of our site.
If you want to speculate, be candid and admit it, but at least limit the amount of money that you are borrowing to what we call pocket money (see pocket money
on our site). Our concept of pocket money automatically sets a limit on loans for investing to 5 to 10% of the  equity portion of your portfolio. You will sleep better at night and, no matter what, will not cause irreversible damage to your wallet. And over time the costs and risks of borrowing to invest may even lead you to end your borrowing fling.
Plan for repayment
Determine the precise annual interest amounts payable on your loan, the maturity date of the loan when the principal becomes payable, and each of the events that could allow the lender to request the accelerated repayment of the loan.
Determine in each case the source of the money you will use to pay the interest or principal, as appropriate.
Avoid negative gearing
Avoid what is called negative gearing, i.e. borrowing to such an extent that your interest costs exceed your investment income (see Wikipedia ), because in difficult markets few people like to dip into their non-financial assets to cover a current account deficit (the amount by which your interest expense exceeds your investment income), particularly if the value of your investments are also declining.
Try not to borrow at a variable interest rate, which is typical of borrowings under a line of credit or margin loan. A subsequent increase in interest rates can put you in a situation of negative gearing and create an unpleasant surprise. If you need to borrow at variable rates, give yourself a cushion by reducing the amount of the loan to cover the eventuality that the rate may increase suddenly.
Manage taxes
Try to structure your debt so that interest is deductible (we will return to this in our third commentary). But a word of caution: borrowing for the sole purpose of creating deductible interest is never a good idea.
Check your Asset Allocation
Check before you borrow whether your asset allocation will still be appropriate in your circumstances after the transaction; see Asset Allocation . And if you do not know the asset allocation
that is appropriate for you, figure it out
(seeking expert advice if necessary) before moving forward.
Avoid the short term / long term trap
Do not borrow short term to buy long term assets.
A margin account with a broker only enables you to borrow short term (a short-term loan because the broker can call-back the loan at any time). We strongly recommend only using it to borrow for transitional reasons, for example: you sell securities and the settlement date is three days off, but you want to immediately buy another title with settlement date of one day. The margin account allows you to borrow to cover the interim shortfall. This is an excellent use of a margin account.
But using this account to simply buy and hold stocks (common shares should be considered long-term investments) is a speculative, high risk transaction, a type which our site discourages.
Diversification
Borrowing to invest introduces an additional level of risk in your portfolio.
Do not add, in addition, another risk by buying non-diversified assets with the proceeds of the loan.
Such assets (for example, the shares of a small number of companies, even reputable companies) often lose value faster than the market in general, in which case you have incurred a loss but you must still repay the full amount of the loan.
For us, purchasing a diversified set of assets with the loan proceeds, for instance using an index fund, minimizes this additional risk; see-Diversification and asset classes
and Index funds (ETFs and Index Mutual Funds) .
Conclusion
In the third and last commentary in this series, we will look at interest deductibility.
Comments from readers:
I think it is a good time to borrow more investing. I think it makes sense to borrow money to invest in corporate bonds, high yielding common as well as preferred shares. One way of borrowing money is to short government bonds. Going short government bonds and then being long corporate bonds is a way
of betting that the yields between corporate and Gov’t bonds will narrow.Ken Hawkins- Second Opinion Investor Services
|
