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 ?