For most, a paid off home is a lifetime ambition that represents financial freedom. For others, all that untapped equity is dead money.
If you’re in the minority of homeowners who are disciplined with investments, financially secure, risk tolerant and don’t rely on home equity for retirement, a paid off home can work against you.
The Canadian Real Estate Association pegs the average home value at $748,439 and the average homeowner has more than 72-per-cent equity, according to 2021 data from Mortgage Professionals Canada.
If we assume you borrow the maximum 80 per cent of that average home’s value, you’re left with about $394,000 in investable equity. That’s assuming one is well-suited to such a strategy – a key point I’ll touch on below.
Canada’s richest families have leveraged their assets to grow their net worth for years. But for regular financially secure Canadians, borrowing to invest is too often dismissed. That’s largely because regulators take a dim view of it as generally risky, owing to the complaints they get, particularly in down markets.
One could argue that’s not fair to the strategy overall. Using data from their well-known book Lifecycle Investing, Yale professors Barry Nalebuff and Ian Ayres argued: “It is sensible, even responsible, for young investors to use leverage” to invest in stocks.
The challenge when investing with borrowed money is that people’s behaviour is often less rational, says Doug Robinson, a certified financial planner at Veritable Wealth Advisory. “Temperament and discipline are easily lost during times of crisis.”
That’s a problem because the last thing you want to do when investing borrowed funds is sell good assets in distress.
That said, if a homeowner is wholly compatible with leveraged investing, then “as long as after-tax return of the investments is greater than after-tax cost of borrowing, it’s going to make sense,” Mr. Robinson says.
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He’s used this strategy himself twice before, in September, 2001, and December, 2008, intentionally during market sell-offs. April of 2020 would have been another ideal opportunity, but he stayed on the sidelines because the market moved so quickly.
This time around Mr. Robinson says he has a home equity line of credit (HELOC) “ready to go,” noting that stock market declines historically last just 14 months on average, inconsequential for those with a holding time frame of a decade or more.
Do’s and don’ts when borrowing to buy stocks
There are countless ways to invest borrowed money: in business ventures, purchasing income properties, home improvements that build future equity and private lending, to name a few. But given that most global stock indexes are now in correction mode, many are borrowing to buy equities.
History has shown time and again that the best time to buy stocks on leverage is when the market is down – substantially. “When good companies lose one-third to one-half of their value, if they were good companies before, they’re probably still good companies,” Mr. Robinson says.
But before securing debt to your home to invest in stocks, know that there are rules you should not break. Never borrow to invest:
- Without sufficient liquidity You must have more than one way to make your loan payments. Otherwise you risk having to sell your investments if things go bad and/or interest rates skyrocket. Investing your entire credit line with no other buffer, for example, can be a recipe for disaster.
- If you don’t have a plan for selling your home People often must sell for reasons they can’t foresee, such as job loss, illness or divorce. Without having another property to secure your investment borrowing, you could be forced to liquidate holdings, thus crystalizing any losses in your portfolio.
- Unless you can afford to lose money Losses can be serious if you’re not diversified, make a bad stock picks or liquidate your assets prematurely. A diversified portfolio of index funds can help mitigate such risks.
- With a short time horizon Mr. Robinson doesn’t support leveraged investing for those with less than a decade-long time horizon. Given a disciplined risk-tolerant investor with a 10-year holding period “the probability of beating a 3-per-cent borrowing rate is high, although not 100 per cent,” he says. Extending out to 20 years, “the likelihood is approaching 100 per cent.”
- Without proper guidance Ideally “you want someone who is a fiduciary” and not swayed by compensation to validate your tax and investing approach, Mr. Robinson says. If you’re more of a do-it-yourselfer, a fee-only certified financial planner can keep your advisory costs down.
- If you have other higher-cost debt that doesn’t produce a return Investing for stock market returns of 7 per cent, for example, makes no sense if you carry debt on credit cards of 19 per cent.
Implementation tips
In terms of financing options, many invest from their HELOC. The payments are interest-only and the interest is deductible if you meet Canada Revenue Agency rules.
Others prefer to lock in borrowing costs longer-term. By doing this, you’re reducing the risk presented by rising interest rates. Problem is, locking in typically requires that you make principal payments, which creates tax accounting complexities, albeit not insurmountable ones.
If you buy stocks with borrowed money, they must be for the purpose of earning income to meet CRA rules for interest deductibility.
For those with spare room in their tax-free savings account, Mr. Robinson says it’s usually wiser to borrow and invest using a TFSA before deploying leverage through a non-registered account. That’s assuming you can meet the monthly interest payments and won’t need to liquidate your investments for several years.
You don’t get to write off any interest with a TFSA, but he calculates you’ll end up further ahead in retirement, given “all reasonable assumptions.” Once your TFSA is maxed out, then it makes sense to consider non-registered leveraged investing, he says.
Naturally, there are infinite caveats to everything above and leveraged investing is not appropriate for the majority. But for a minority, dead equity has a very real opportunity cost.
Robert McLister is an interest rate analyst, mortgage strategist and columnist. You can follow him on Twitter at @RobMcLister.
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