Leveraged investing is defined as borrowing money to finance an investment. You are familiar with the concept of leverage if you've ever:
Borrowed money to make additional contributions to your RRSP
Used a credit line for investing
Bought securities on margin from a stock broker
Both individuals and companies use leverage as an investment strategy; a company with a lot of debt is considered highly leveraged.
Leverage can be an effective way to boost returns in your investment portfolio, but you should also understand the potential consequences of borrowing to invest.
Leverage magnifies your losses as well as your gains, and you must be able to withstand those losses if you are going to use borrowed money to invest. The leveraged investment should be suitable to your investment goals and objectives and consistent with the "Know Your Client" information that you have provided to your advisor. It is both your responsibility and your advisor's to ensure that you understand the investment, and are comfortable with the risk level.
Risk of Borrowing to Invest
Here are some risks and factors that you should consider before borrowing to invest:
Is it Right for You?
Borrowing money to invest is risky. You should only consider borrowing to invest if:
You are comfortable with taking risk.
You are comfortable taking on debt to buy investments that may go up or down in value.
You are investing for the long-term.
You have a stable income.
You should not borrow to invest if:
You have a low tolerance for risk
You are investing for a short period of time.
You intend to rely on income from the investments to pay living expenses.
You intend to rely on income from the investments to repay the loan. If this income stops or decreases you may not be able to pay back the loan.
You Can End Up Losing Money
If the investments go down in value and you have borrowed money, your losses would be larger than had you invested using your own money.
Whether your investments make money or not you will still have to pay back the loan plus interest. You may have to sell other assets or use money you had set aside for other purposes to pay back the loan.
If you used your home as security for the loan, you may lose your home.
If the investments go up in value, you may still not make enough money to cover the costs of borrowing.
You should not borrow to invest just to receive a tax deduction.
Interest costs are not always tax deductible. You may not be entitled to a tax deduction and may be reassessed for past deductions. You may want to consult a tax professional to determine whether your interest costs will be deductible before borrowing to invest.
Your advisor should discuss with you the risks of borrowing to invest.
When you borrow funds to purchase non-registered investments, the interest is only tax deductible as long as you continue to hold the investment or any substituted investment.
There are special exceptions to the rules related to tax deductions on interest costs designed to provide relief to investors who have borrowed money to buy investments that have since declined in value. This allows you to continue to deduct the interest expense on the loaned funds after the sale of the investment subject to certain restrictions, illustrated by the following:
If an investment is sold at a loss and the proceeds are used to purchase another investment, the interest paid on the original investment loan will still be fully deductible.
If the investment is sold at a loss and the proceeds are not used to purchase other investments, the proportion not reinvested will not be deductible.
If instead of selling the investment, you gift it to another family member, or transfer it to a RSP, then that proportion of the interest expense related to the transferred investments will not be deductible for tax purposes.
These rules do not apply to investments in real or depreciable property.