Borrowing To Invest

If you can borrow at prime or even prime plus 1 (2.85% or 3.85% at the moment),where the interest on the loan is tax deductible and you can achieve a return of better than 5 or 6% (after fees and taxes), isn't this a layup?

Maybe!

• The difference between the cost to borrow and the return is "the spread".
• Using borrowed money to invest to make this "spread" has worked well for investors over the last 3 years.
• However, using leverage has significant risk and requires discipline.
• As long as asset prices are rising, borrowing to invest in those assets will provide an accelerated growth rate on the value of those assets.
• Homeowners in Canada (who believe  their home to be an "investment") have been doing this since the mid 1990's and have done extremely well.

However!

• There are great risks that come with this strategy:
• If asset prices start to fall, it will magnify the loss.
• Borrowing institutions won't wait very long to call in their loans if they believe that the value of the assets is going to fall below the value of the loan (or at least require that you "put up" more $$ to support the borrowing).
• In 2008, "over leveraged" investor's had to sell assets to pay down "margin calls" which further exacerbated the fall in equity prices.

As an example, let's examine the relationship between margin debt and the S&P 500:

click on the chart to enlarge

•  Since the beginning of 2013, the debit balances on margin accounts at New York Stock Exchange member firms (lending to investors to buy equity assets) has been leading the S&P 500 higher.
• This can be extrapolated to many equity markets as the cost of borrowing remains very low.
• This does not include those who may use their home as collateral (commonly known as a HELOC) to borrow to invest.
• Margin debt peaked in 2014 and has been moving lower since.
• This may be telling us that investors are growing leery of what value current equity prices hold and are reluctant to borrow further.
• It may also be telling us that the potential for higher interest rates (and higher borrowing costs) may be making investors reluctant to take on the additional risk of borrowing to invest.

If you are going borrow to invest:

• You want to be certain that the assets you are purchasing represent good value.
• There is danger in buying over valued assets. (ask Canadian home purchasers in the early 1990's or equity investors in 2000 and 2007 about their experiences).

Is now the right time to borrow to invest?

• I would counsel No.
• Low interest rates have quite possibly inflated current asset prices significantly.
• Interest rates may remain low a while longer, asset prices may rise a bit more (in the short-term).
• However, it is best to borrow to invest when asset prices are cheap and the risk of lower asset prices is significantly reduced.
• At the moment, this does not appear to be the case.

 The views expressed are those of the author, Scott Tomenson, a Raymond James Financial Advisor, and not necessarily those of Raymond James Ltd. It is provided as a general source of information only and should not be considered to be personal investment advice or a solicitation to buy or sell securities. Investors considering any investment should consult with their Investment Advisor to ensure that it is suitable for the investor's circumstances and risk tolerance before making any investment decision. The information contained in this blog was obtained from sources believed to be reliable, however, we cannot represent that it is accurate or complete. Raymond James Ltd. is a member of the Canadian Investor Protection Fund