investment loans
Investment loans, also known as leverage investing, are a financial tool used by many investors in Canada to increase their returns on investments. People usually borrow for one of two reasons, either:
- To buy a big ticket item, like a car, which generally decreases in value over time or,
- To purchase a big-ticket that has the potential to increase in value over time, like a home or RSP.
With an investment loan, clients borrow to make a lump sum investment purchase that has the potential to grow in value over time. These loans are essentially borrowed funds that are used to purchase securities, such as stocks or bonds, with the hope of earning a higher rate of return than the interest rate paid on the loan.
How does an Investment Loans Work?
Investment loans work by allowing investors to borrow money from a financial institution, such as a bank, to invest in the stock market or other securities. These loans are typically secured against the investor’s investment portfolio and require regular interest payments. The amount that can be borrowed varies depending on the value of the investor’s portfolio and the financial institution’s lending criteria.
The interest rate on investment loans is usually lower than the interest rate on other types of loans, such as credit cards or personal loans. This is because the loan is secured against the investor’s portfolio, which acts as collateral. However, the interest rate on investment loans is typically higher than the interest rate on traditional mortgages.
An investment loan has the potential to generate greater returns for your client than a traditional investment strategy. Here’s why:
- Accelerates savings through a larger initial upfront investment and compound returns.
- Compound returns on an investment means that returns are calculated not only on the initial investment, but also on the accumulated growth from year-to-year.
- Generally speaking, interest paid to borrow money to earn investment income is tax deductible. When the interest is deducted, it can be an effective way of reducing the overall cost of an investment lending strategy. Interest is not deductible in all circumstances.
For example, if the only earnings produced by the investment are capital gains, interest paid cannot be claimed. Additional restrictions apply for residents of Quebec. Please consult with a tax specialist for information on deducting interest.
Benefits of Investment Loans
- Investment gains have the potential to reach financial goals faster. By using borrowed funds to invest in the stock market, investors can increase their returns on investment, as long as the returns on the investments are higher than the interest rate on the loan. This can be especially beneficial for long-term investors who are looking to build wealth over time.
- A lump sum investment starts compounding right away, rather than waiting to build your savings with a traditional strategy.
- There are potential opportunities to reduce overall cost of an investment lending strategy through tax deductions. In Canada, interest paid on investment loans is tax-deductible, which can help to reduce the investor’s overall tax liability. This can further increase the investor’s returns on investment. Please consult with a tax specialist for information on deducting interest.
Risks of Investment Loans
- Leveraging involves greater risk than purchasing investments using only your own cash resources because it has the potential to magnify investment losses.
- You are required to repay the loan, including interest, regardless of the investment return.
- An investment loan may limit your access to credit due to the outstanding debt of the loan. (specifically access to other credit products, e.g. mortgages, HELOC, etc)
- Another risk of investment loans is the potential for margin calls. Margin calls occur when the value of the investor’s portfolio falls below a certain level, which triggers the financial institution to demand additional collateral or payment to cover the loan. This can lead to forced selling of securities and further losses for the investor.
Who can generally use investment loans?
In general, individuals who have the following are better suited to leverage investment loans:
- A long investment horizon
- Available cash flow: You need to be prepared to pay the loan from sources such as employment income or other investments.
- A high risk tolerance: it is essential to have the available cash flow to handle regular payments, as well as the ability to handle changing market conditions and interest rates.
Anyone considering this strategy should seek the advice of a qualified financial advisor. Contact us to know more about investment loans.