Using a HELOC as an investment strategy: not as taboo as you might think

Borrowing from a home equity line of credit

You know, Martha, in some circles, leveraging—or borrowing to invest—is a taboo subject. I find that funny because there is much less controversy when people borrow to:

• Buy a car, which depreciates in value;
• buy a house, which normally appreciates, but it can decline;
• or take a vacation as a lifestyle investment.

So, why is there controversy around borrowing to invest? It is probably due to a lack of understanding, coupled with the fact that when leveraging goes bad, it’s not good.

Let’s talk about leverage. If you borrow $100,000 at 8%, what rate of return would you have to earn on your investments to break even? Would you guess 8%?

Most people would agree with that answer; it sounds logical, right? I mean, if you borrow $100,000 at 8% and paid $8,000 in interest costs then that would mean you would have to make $8,000 on your $100,000 investment to break even, which is 8%. Got it? Good.

But that answer may be wrong depending how you invest.

The break-even return on investments may be lower than the borrowing cost when you take into account if you consider the way a tax deduction works and the way non-registered investment income—depending on the type of income—is taxed.

Investing strategy: How investing from a loan affects taxes

In Canada, when you borrow money to invest, the interest cost is considered a carrying charge on your income tax return. That creates a tax deduction no different than an registered retirement savings plan (RRSP) contribution. Looking at this in concrete terms, if your marginal tax rate is 30%, your after-tax cost of borrowing is 5.6% on a 8% interest rate, well almost. 

It is not quite that simple.  It also depends on the length of time you hold the investments and the investments annual distributions.  Let me give you an example using Talbot Stevens Leverage software, which you can download for a free 30 day trial. 

If you have a marginal tax rate of 30% and borrow $100,000 at 8% over 10 years to invest in a regular mutual fund, in Talbots software, your break-even investment return is 6.2%. Extend the time frame to 20 years and the break even is 6.1%. Increasing the marginal tax rate to 40% reduces the break even return to 5.6% over 10 years and 5.4% over 20 years.

As you can see the tax efficiency of your investments can impact the net benefit of borrowing to invest. The less tax you pay on your investments as they grow, the more money you have invested, and the more the returns can compound over time. Assuming you are paying the tax from your investment account.

If you borrow at 8% and invest in 8% guaranteed investment certificates (GICs), (I know, where can you get an 8% GIC?), you won’t come out ahead. That’s because interest income you earn is fully taxable. Sticking with our 30% marginal tax rate example, if your after-tax cot of borrowing from above is 5.6%, your after-tax cost of investing in GICs at 8% would also be 5.6%. You’d pay 30% tax on the 8% interest income earned.

If you invest in stocks, there may be an advantage though.

Only 50% of a capital gain is taxable. Even then, not until you sell. And if you invest in Canadian stocks, there is a tax credit for Canadian dividends called the “dividend tax credit’ that leads to a lower tax rate as well that varies with your income.

With that in mind, do dividend-paying investments make sense? What’s your reason for selecting dividend-paying investments? Is it because you feel those investments are safe and provide good returns? That’s an OK reason, but if you could find investments with a similar level of risk and rate of return which paid less in distributions/income, then you may be better off from a tax perspective.

Were you thinking of using the dividends to pay some of the interest charges? You can do that, but I would advise against it. Don’t do leverage unless you can easily make the interest payments out of your regular cash flow.

Six considerations for borrowing against a HELOC to invest

A HELOC is a home equity line of credit. Here are a few things Canadian investors should consider before borrowing any money to invest:

1. Use a separate HELOC for your source of investing funds. This will make your taxes easier for tracking the interest.
2. Hold a separate account just for the leveraged investments; again, this will help with tax accounting.
3. While you’ll want to invest according to your specific profile, investing into a broad market portfolio is less risky than a concentrated portfolio.
4. Don’t use systematic withdrawals from the investment to make interest payments.
5. Plan to invest for at least 10 years. If you have a shorter time horizon, leveraged investing can be riskier than if you held the investments for longer.
6. Remember, leveraging magnifies returns up and down. If your $100,000 goes to $80,000 and you have to sell, you will still owe the bank that “lost” $20,000 (the difference between the $100,000 you borrowed to invest, and the $80,000 value of your investment when you sold).

Four questions about leveraging a HELOC

Finally, when it comes to leverage don’t think just about investment accumulation but also think about how you can use the interest tax deduction. Here are a few quick thoughts:

1. Will it reduce your income so you can get more of the Canada Child Tax Benefit, the Guaranteed Income Supplement (GIS), Old Age Security (OAS) and the Age Credit?
2. Will the tax deduction offset the tax owed on registered retirement income fund (RRIF) or corporate withdrawals?
3. Can you use the tax deductions to pay off your mortgage faster and accumulate investments, i.e. the Smith Manoeuvre?
4. Interest on the interest that is tax deductible is also tax deductible so consider paying off non-tax-deductible debt before making interest payments on your leveraged loan.

Still skeptical? I encourage you to download the free trial of Talbot Stevens’ leverage software to see for yourself. (Here is a demonstration of the software.)

I hope I’ve given you some things to think about, Martha, and I haven’t made it look like everyone should run out and start leveraging. If you have the cash flow, borrow within your means, stick to a broad market investment, and have a long-time horizon, you’ll greatly improve your odds for success.

Read more about investing and mortgages:

• Borrowing money to invest
• How to invest down payment funds while timing the real estate market
• Should you hold your mortgage inside your RRSP?
• Contribute to RRSP or pay off mortgage?

The post Using a HELOC as an investment strategy: not as taboo as you might think appeared first on MoneySense.

Allan Norman, MSc, CFP, CIM

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