The Bank of Canada’s current interest rate sits at 0.25% - the lowest it’s been for a very long time. All other interest rates (bank prime rates, mortgage rates, automobile finance and leasing rates) are based off of this core figure. What this means is that right now, money is cheap.
At the same time, the equity market is going gangbusters. The average Canadian domiciled global equity fund has returned a stellar 33.2% after fees on a trailing 12-month basis. This, in combination with social media and the rise of meme stocks, have likely prompted some investors to do what seems obvious – borrow to invest.
The concept is seemingly simple – if you can borrow money at a low rate and invest it to get a rate of return higher than the rate you borrowed at, you come out on top right? Well, sort of. What you are really doing when borrowing to invest is called leverage. Leverage is like an accelerator on your investments, which can work in your favor, but can also lead to disastrous results. So before going out and getting a home equity line of credit and investing the proceeds, consider these two scenarios:
For a larger version of the table, click here.
The table assumes that an investor invests $1000 under two scenarios. In the ‘boring’ scenario, the investor takes her hard-earned cash and invests in an index fund that tracks Canadian stocks. After 12 months (using actual returns of the Morningstar Canada TME Index in 2019) she ends up $227 richer than when she started.
In the YOLO scenario, the investor first goes to the bank and borrows $1000. She takes the borrowed money (for which she pays small amount of interest each month) and invests it in the index. At the end of the 12 months, she’s now $207 richer inclusive of the small amount of interest that she now owes to the bank.
And that’s the ‘good’ scenario. Like everything in life, it works both ways, so let’s consider the ‘bad’.
For a larger verson of the table, click here.
This second table looks at the same index, but when times were not so good (calendar year 2018). In the ‘boring’ scenario where the investor just invests her own money, she ends up with $915. In the YOLO scenario, the investor is now in debt by $105. The key here is that the amount the investor owes to the bank stays static, despite the proceeds’ value going up and down.
Most seasoned investors know that a 12-month period is not really an ample amount of time to realize returns. However, being in debt can often change the mentality of holding onto a losing position in that it can add pressure. In the case of taking out equity from your home, this pressure can be immense and can have very real consequences. Moreover, interest rates themselves have nowhere to go but up. When this inevitably happens, the cost of servicing debt will also increase. How long will you be able to hold onto your losing position before the debt becomes too much? This combination can make it very difficult to remain disciplined and calm when making investment decisions.
Borrowing to invest (a.k.a. leverage) is an amplifier to investment returns, for better or for worse. Before you do it, consider whether investing proceeds from a loan is in line with your risk tolerance (your attitude toward risk) and also your risk capacity (your financial ability to withstand losses). Moreover, it would be prudent to consider the consequences of defaulting on a loan where the collateral is your primary residence (like a Home Equity Line of Credit or HELOC). Above all else, remember that investing is supposed to be boring.
This article does not constitute financial advice. It is always recommended to speak with a financial advisor or investment professional before investing.
