Using an investment loan to buy stocks is not something I suggest new investors. The basic rationale of using a loan to buy stocks is to build wealth and dividend income over the long term. The theory is that stock prices increase over time, and if you have invested in stocks that pay dividends, you will be building wealth and a dividend income stream much faster than you could than investing on your own. You effectively use other people’s money to build wealth, such that the return on your equity is magnified by using a loan.
Lets look at an example that illustrates this. Assume that you are able invest your capital in GFI stock and your stock increases 10% per annum. In the first example, you invest $100,000 of your own money. In the second example your borrow an additional $100,000 and invest a total of $200,000.
You can see above that borrowing $100,000 to invest $200,000 in total can increase your total portfolio value to around $520k after 10 years instead of $260k where you hadn’t borrowed to invest. That will increase your return on equity to around 20% p.a instead of 11%p.a, because you have still only invested $100,000 of your own equity . That’s a big increase!
The calculation above is not complete because it doesn’t include the interest expense that you are paying on your loan. Assuming that you pay a 5% p.a interest on your loan, your effective return on equity would be something closer to 18% p.a over the 10 years.
Tax saving on interest
One of the other nice advantages of using investment lending to purchase dividend paying stocks is that you are able to deduct the investment interest that you pay on the loan up to the amount of investment income that you have earned.
Let’s look at an example that illustrates this.
Assume you have earned $500 in dividend income for the year. You have a $10000 investment loan on which you pay 5% interest. Your effective interest cost of $500 will be offset against your dividend income of $500. If your marginal tax rate is 20%, then your effective interest cost will only be 80% *$500 or $400.
When taken with the favorable return on equity that an investment loan can give provide you, borrowing to invest in high quality dividend paying stocks can not only boost your long term wealth and dividend income, but be a very tax efficient way of doing so.
Pitfalls of borrowing to invest
Of course, the rosy example of GFI stock above that increases nice and linearly each year at 10% p.a doesn’t generally happen in real life. There will be ups (and sharp downs!) in the movements of the market and even in an individual stock such as GFI over the 10 year period that we looked at above.
Investment lending does need to be used responsibly, in moderation and with the right types of investments. A failure to do so can leave you exposed if there are sudden market moves downward.
I have been using investment lending to build my dividend stream almost since the time I first invested. While the ratio of my loan to total equity is now approximately 10%, there was a time just before the 2008-2009 crash that my loan balance to portfolio value was almost 50% (ie I had close to a $200k loan on a $400k portfolio). Having a debt to equity ratio that is so high leaves you in a tough position should asset values plummet.
And we all know what happened during 2008 to 2009. As stock prices declined, I was forced to take proactive action to sell stock so as to not receive a dreaded margin call. This is when your lender gives you a call and tells you that your equity balance isn’t sufficient to cover your loan amount, so you need to sell stocks or inject some cash into your account. I estimate that I probably lost some $50k as a result of needing to make forced sales at wrong times.
I share this lesson partly in the spirit of helping others to avoid similar mistakes with investment lending and to ensure that if you do consider investment lending, you do so with your eyes fully open in terms of what could result if you don’t manage your loan properly.
So if I have had such a costly experience with investment lending, why do I still persist with any investment lending at all in my portfolio ?
I still believe that investment lending, used carefully and in moderation can be a very tax effective way to build long term wealth. However for me now, investment loans are less a part of a long term strategy and more about having flexibility to invest in the market in advance of having funds available from my dividends to reinvest. The margin loan helps me opportunistically deploy capital when markets correct or stock prices decline even if I don’t have dividend income on hand at the time. The loan gets repaid once dividend income arrives.
My Key Takeaways:
1. Investment loans can be an effective way to increase your return on equity and build long term stock wealth and a steady dividend income steam in a tax effective way.
2, Investment loans need to be managed very carefully. They come with high risks, including forced selling at the worst times if equity markets collapse. You need to be firm with a cap on your debt obligations to total portfolio value. While lenders may provide you with as much as 50-60% debt: portfolio value, one should be very cautious in exceeding even a 20% limit in my view.
3. Your ability to take advantage of falling markets can be greatly limited if you have significant debt obligations hanging over your head. Instead of being able to buy at those times, you become a forced seller at the worst possible time.
4. Investment loans can be a very effective way to take advantage of dips in the market to add to equity positions. There will be occasions that you don’t have surplus cash on hand to take advantage of short term dips in a stock or the market in general, An investment loan can allow you to take advantage of such dips.
What are your views on using debt to buy stocks ?
Now is a good time to use margin. I borrow at 1% and buy high yield stocks and preferred stocks that pay a suitable spread. The Fed is making money cheap it is easy to make money this way. To get this cheap money you need to go to a professional broker not the mainstream brokers.
This isnt sexy but i earn over 10% per year on borrowed money. Here is a list investments that i have in this portfolio
O.d – realty income 6.75% preferred
Arr-a – armour reit preferred 8.25%
Lorillard (lo) – 5.25% yield
Phillip Morris (pm) – 4.0% yield
The interesting trait here is that virtually any dividend stock can earn you a spread (even Apple if you so chose). I pick companies with high margins and stable earnings, it is easier to be successful.
Any capital gains are extra return.
six figure investor,
Thats a strategy that I have pursued myself in the past. If the dividend growth rate from the companies that you have borrowed to deploy capital in are able is higher that you have borrowed at, then you have income arbitrage in my view. I think this works well when interest rates are low. The key is to get sustained increased in dividend income over time.
SFI,
Which brokerage company lets you borrow at 1%? I am only aware of Interactive Brokers letting you do that. ( they do charge you monthyl fees however)
I’m not a big fan of using debt to invest in general, though I would if I had enough information, like if it was an investment for my own business. Money definitely is on the cheap side these days.
Kevin, thanks for swinging by!. I understand you view, i’m certainly more reluctant to borrow to invest these days. I consider it akin to borrowing to invest in a house. Ultimately both help you build long term wealth. The difference is that your house doesn’t appear to go up and down in value on a daily basis, like your stocks do and isn’t generally subject to dramatic moves up and down
I won’t invest on margin. I’ve been debt free my whole life, and the only time I’m hoping to break that streak is when/if I buy a house.
I try to keep my risks at a minimum and the risk of becoming a forced seller is a bit too much for me.
Knowing your limits is one of the hallmarks of a good investor. And my limit is debt.
Very sound and understandable position MyFI. Its very important to make financial decisions that you are comfortable with and that don’t leave you constantly pondering adverse scenarios. Borrowing to invest can do that to people if they don’t manage their gearing properly.
I’ve never really considered investing on margin. I think I’ll have to look into it a little further. It sounds like it can be a real useful strategy when used properly.
If I was to start out investing on margin, I probably wouldn’t start with individual stocks. I think I’d look at an index fund and keep my debt:portfolio at around 20%. You’ll be exposed to a lot less volatility that way, and with such a low leverage amount, greatly reduced chance of any forced sale of stock or having to invest cash into a portfolio to cover a margin call.
Thanks for the tips!
I considered buying stocks on margin and did a fair amount of research on it before I started my journey towards financial independence. I decided it’s not for me.
I’m a little too risk averse for it, which is funny coming from someone who is almost 100% long equities. I may not hit home runs doing what I’m doing (buying quality dividend growth stocks at attractive values every month, and using only my own money), but I know that with enough singles and doubles I’ll eventually win the game.
Best wishes!
DM,
I think you have to be totally comfortable with all the potential risks and downside of buying on margin before you take on something like that. Otherwise you really run the risk of being underprepared if the tides turn and you are overexposed. Being constantly on edge about downside risks doesn’t make for a contented investment journey!
I typically don’t use debt to finance long term stock positions but definitely see the advantage of doing so. When I was single and trading currency I use to use leverage like it was going out of style. Unfortunately I have seen the negative effects of this. An unfortunate event can literally result in a margin call and force individuals out of stocks that are great businesses.
You are very brave to throw an opinion such as this out to the PF community. But what you’re suggesting is really not a whole lot different than what real estate guru’s talk about. I do like the concept and see the mathematical benefit to using leverage.
I think it just all depends on the deal you get. Suppose I was able to secure a loan at 2%. For sure I could find some low risk dividend paying stocks at 3 to 4% to leverage my position. But what about a 5% or 6% loan? Now I’m gambling that I’ll have sustainable capital gains in addition to that guaranteed dividend payment, and my profit margin is decreasing. So now my confidence is starting to wavier.
Regardless, this is a very interesting strategy.
Thanks for coming by My Money Design!. Debt is something that needs to be considered and managed extremely carefully. Its certainly not for everybody. As you suggest, the use of leverage will vary on a number of factors including rates that you can borrow at and what you invest in. At the end of the day, you are financing an asset class. Whether that asset class is real estate or share investment doesn’t make too much difference to me in my mind, particularly if that interest is deductible and I have set firm limits of my debt exposure.
I use my margin account to purchase stocks from my watch list that take a dip. I never kept real track of it, since it is just there, but it has HAD to help my returns by 5 or so % since I could buy on the dip. I don’t keep it open though. I usually try to pay it back within a few months.
In my view, thats a very good way to utilize margin. Its almost like a “pay in full” strategy for credit cards at the end of the month. You can utilize margin to take advantage of temporary dips in stock price that you don’t have cash reserves to pay for and then pay back as soon as possible. You will make more over time from the compounding effects of such a move than what it costs you in interest to do so.
Integrator, I am happy finding this article and seeing one investor accepting leverage as a portfolio building tool. Almost always I’ve seen everybody running away from margin and screaming.
I love this tool and as you said you can get a lot better performance. I believe in leverage in early years of portfolio building and slow deleveraging in the final years. I’ve been practicing this for a few years and now when rebuilding my portfolio (from my previous gambling adventure), it moves my portfolio up strongly. I have my own 7k controlling 19k and receiving dividends from other people’s money. Of course you have to know how to manage such account otherwise margin calls will ruin you. And my dividend income is still larger than interest I pay to my broker.
Thanks Martin. I have successfully deployed leverage for many years in building wealth and income. I believe it can play an especially valuable role early on when someone is trying to really build up wealth. Of course, it should be managed properly. I use leverage more sparingly now, but still believe it can play an important role in an investors portfolio. My portfolio wouldn’t be where it is today without leverage providing a boost.
I’m a little late to this topic but I’m curious what your thoughts are on selling puts on margin. I’ve started a strategy of selling cash secured puts on high quality dividend stocks, and have recently ventured beyond having complete cash security on all positions. The broker requires that you have a margin account to do this but technically you don’t have to borrow the money (nor pay interest) because you don’t own the stock. You just have an obligation to buy if the price drops. I see this as another way to profit from the same calibur stock you’re interested in, even if the stock is temporarily over-priced.
ArrandArr,
Thanks for stopping by. Selling puts is a strategy that I myself am very interested in, and as you point out, is a good way to get into a quality dividend stock that may be a little expensive, or to create a synthetic dividend on a position that you don’t actually on. I believe selling these puts on margin rather than cash secured can be a very good way to boost your overall Return on Equity, just like using debt for stock positions. If managed properly, and calculated on the basis that some % of these may be called in during a correction, then I don’t see an issue with it. It all comes down to a question of how well you manage overall exposure and potential obligation to buy stock.
I’m considering getting a low rate interest only arm, then using that to buy a dividend etf 50% on margin. I’ve calculated that I should net 4% per year, and should earn 3x net what I would without using home equity.
The etf is global x superdividend. It’s newish but seems to track well with the market, has low volatility for less decay during stagnant times, and assuming I pick it up after a correction, this seems like a good strategy for a strong start to growing money.
Any thoughts on this are appreciated.
Nox,
Gearing into dividend stocks can be a good way to boost your Return on Equity. I’ve done this in the past myself. Borrowing at 2-3% and getting a return of 4-5% is pretty good arbitrage. The main problem I see with the ETF is the fees that may be charged, particularly if its global. Fees could be greater than 1%, which may eliminate some of the upside that you are getting from low cost borrowing.
Thanks for the reply. I’m somewhat noobish, but reading the prospectis, fact, sheet, and site for the ETF indicates it’s .45% expenses, which from other ETFs I’ve looked at is about par.
0.45% is a pretty reasonable expense ratio for an international etf, i agree with you. Good luck with the strategy!