I must admit I’ve always been averse to borrowing money. Once, after assiduously paying off our home mortgage, I even cashed in some of my RRSPs rather than borrow again to finance home renovations.
Perhaps if I had calculated the lost tax-sheltered RRSP growth against the relatively short-term interest cost of the mortgage I would have worked harder to overcome my abhorrence of debt.
But today, with both saving and borrowing interest rates so low, wouldn’t it make sense to borrow money to invest – especially when the borrowing costs are often tax-deductible?
Such leverage works wonderfully when your investment rises in value. But it can prove disastrous if your investment falls and you have to cash in.
Here’s why – and remember, preservation of capital is the first rule of investing.
You have saved $2,500 to invest. You borrow $7,500. You make a $10,000 investment.Ignoring tax and buying/selling costs:
(1) The investment rises 20 per cent to $12,000. You sell, pay off the $7,500 loan – and your $2,500 savings have grown an impressive 80 per cent to $4,500.
(2) The investment falls 20 per cent to $8,000. You sell, pay off the $7,500 loan – and your $2,500 savings have dropped a disastrous 80 per cent to $500.
Clearly, borrowing at low interest rates to invest doesn’t necessarily lead to profits.
Leverage is simply another (risk) factor to consider.
However, the current low interest climate should motivate you to review all your debts to ensure you are paying as little interest as possible. Depending on the costs, refinancing could make sense.
Also look at restructuring personal (non-deductible) and investment (often deductible) debts. Perhaps you plan to sell some investments to lock in a capital gain.
You could use that money to pay off personal debt, then borrow to buy replacement investments. Your net financial position hasn’t changed but now you can deduct the investment loan interest.
Mike Grenby is a columnist and independent personal financial advisor; he’ll answer questions in this column as space allows but cannot reply personally - email [email protected]
