August 17, 2021
With interest rates extremely low and the sharemarket rising, people start wondering if they should borrow to invest in shares and increase their portfolio even faster.
After all, more investments means more gains, right?
Well yes, but it’s not quite that simple. In this article, we’ll discuss:
Here’s why you might be interested in taking on some debt to increase your share portfolio.
Here’s where many people get it wrong.
They say “my interest rate is 4%, and my tax rate is 37%, so my investment loan is really costing me 2.5% because it’s tax deductible.”
This would be correct if you earned zero income from your investments. But in that case your interest won’t be deductible because you can only claim interest expenses if the debt has been used to produce income.
Here’s the ATO’s statement regarding ‘dividend and share income expenses’:
“You can claim a deduction for interest charged on money borrowed to buy shares and other related investments that you derive assessable interest or dividend income from.”
“Only interest expenses incurred for an income-producing purpose are deductible.”
You borrow to invest. Your investment pays some income, while ideally growing in value. At tax time, you declare your investment income as ‘income’ and the loan interest as a ‘deduction’.
If the income earned is more than the interest paid, you’ll actually pay more tax. If there’s a cashflow loss, that’s when you may end up with a tax refund. Just like a property investment.
Say your interest rate is 3%, and you’re earning 3% in income from your investment, your tax return is…. zero. Because your investment income = interest costs.
In this case, your cost of debt is still 3%. But that’s only income, we’ve also got growth. So let’s see how the maths stack up over a 15 year period.
This strategy only makes sense if your total return after tax will be higher than your interest costs. And that ‘profit margin’ should be decent, because why take a large risk for a small gain?
Say you borrow $100,000 to invest into shares. Using some simple numbers, let’s assume your interest rate is 3% and your long term return will be 7% per year, made up of 3% income and 4% growth.
In this case, you generate a yearly profit margin of 4% on the borrowed money. Yes, returns might be higher, but interest rates might be higher too. Feel free to use different numbers.
Since income equals the interest paid, there’s no tax owing, nor do you get a tax refund. And of course, growth on your shares is untaxed until sold.
So it’s a simple equation: $100,000 invested for 15 years at a return of 4%. A simple compound interest calculator tells us our end balance is roughly $180,000.
For every $100,000 of debt, you’ll make an extra $80,000 over 15 years. Definitely not bad, but not mind-blowing either.
With a longer timeframe and more debt, the more those additional gains multiply. Now let’s look some of the options available for borrowing to invest.
With this method you use some of the equity in your home to invest in shares.
Say your home is worth $500k and your mortgage is $300k. You could apply for an additional loan of say $100k to invest with, provided you meet the bank’s lending critera etc.
Of course, you might want to consider using a debt recycling strategy too.
Make sure this new loan is separate from your current home loan so that you can easily record the interest each year for tax purposes. You can do this either with your bank or by getting a mortgage broker to help you set it up correctly.
You then send this cash to your low cost brokerage account, and buy your chosen shares. Using home equity to buy shares (compared to other options) has a few benefits.
You have much more control, with basically zero chance of a margin call. The interest rates are much cheaper. And you don’t need an existing share portfolio to get started.
Keep in mind you’ll need enough spare cashflow to pay the mortgage each month as dividends are usually paid every 3-6 months. And ideally, this new loan will be an interest-only loan.
This helps keep your repayments low so you can direct more cash to additional investments or paying down your remaining non-deductible home loan.
If you’re a beginner, I strongly recommend you start slowly, rather than dumping a large chunk of money into the market at once.
Another common way of borrowing to invest is using a margin loan.
The good thing about a margin loan is your home and investments remain completely separate. You borrow against the value of your shares rather than your home.
The downside is, rates are much higher than when you borrow against property – usually 5-7%. The lender also has more control and the loan-to-value ratios are more strict.
If the market falls, you might be ‘margin called’, meaning you’ll be asked to tip in more cash to reduce the size of your loan, or the lender will sell some of your shares to reduce the debt.
With a home loan, as long as you keep up repayments, the bank isn’t going to care whether your shares are up or down – in fact, they won’t even know. If going the margin loan route, keep your LVR low (say 30%) to avoid this risk.
One of the cheaper margin loan providers in Australia appears to be a firm called Leveraged, which is backed by Bendigo & Adelaide Bank. Their ‘direct investment loan’ comes with a rate of just over 4% (at time of writing).
Bell Direct also provide margin loans for less than 4% – see here.
Just to be clear, I haven’t used these myself or thoroughly researched the products, so these aren’t recommendations.
I’ve also heard of people getting margin rates around 4% from banks, by shopping around and negotiating to see who really wants new business.
This one has become a popular choice in the last few years. NAB created a special margin loan called NAB Equity Builder, which works kind of like a home loan, but for shares.
You borrow some money, contribute some of your own, and agree to make principal & interest repayments each month like a mortgage. By committing to these repayments, NAB say there will be no margin calls.
Loans start at $10,000 and you simply need a cash deposit to get started or a share portfolio to borrow against.
The interest rate is currently quite low at just under 4%. While all this sounds pretty good, NAB are the only one offering a loan like this (as far as I know).
That means they have a fair bit of power to change the rules, jack rates up, and so on, knowing you can’t get the same thing elsewhere. That may seem pretty unlikely, but it’s still something to consider.
No. Just, no.
The rates on these types of loans are still mostly in the ridiculous range of 7-10% or more! You will be doing well to simply break-even with an interest rate that high.
If you can’t access any of the options above for whatever reason, just keep it simple and work on your savings rate.
Interest rates won’t be this low forever. If rates rise 1%, 2% or more, how does that change your strategy?
Without debt, you’ll barely blink. By investing with borrowed money, you’ll be acutely aware and feeling less comfortable with each rate increase.
You’ll quickly resent having to make loan repayments if you’re not making gains, or worse, sitting through nasty losses. Leverage can quickly turn a simple investment plan into a miserable experience.
When your investments fall in value, your debt remains the same. So your equity is shrinking before your eyes. Most people have enough trouble coping with market downturns as it is. Adding debt makes it even harder.
Using leverage to juice your returns looks fantastic on a spreadsheet. But in the real world where things don’t go up in a straight line, it’s not so easy.
When taking on extra debt to invest, you need to meet the repayments. For this reason, some people go for shares where the income they receive will be higher than the loan interest.
This is much easier psychologically, and practically, because you’re not having to dip into your own income to cover the shortfall, and you’re even getting some positive cashflow.
On the other hand, lower yield higher growth investments are more tax effective since you can potentially claim the cashflow-loss as a tax deduction. Plus lower yield options (like global shares for example) tend to give you greater diversification.
There are pros and cons to both options. You can always choose a nice middle ground, where you aren’t warping your investment plan to either chase high yields or optimise for tax.
It’s best if you can invest using debt the same way you would if no debt was involved.
Using debt to magnify your returns can work well if you’re still working. But when you’re looking to step off the hamster wheel and cruise into a state of independence, debt can be tricky.
Say you’ve got an investment loan charging you 4%. If your investment portfolio is producing 3% income each year, it’s actually eating into your available cashflow to live on.
Now sure, your portfolio is hopefully growing in value, but keeping that debt around arguably puts you in a less certain, less enjoyable position.
You’re also more affected by interest rate rises eating into the returns you can use to live off. Having negative cashflow investments in retirement is not as fun as having dividends hit the bank and knowing it’s all yours! 😉
On balance, borrowing to increase your investments usually doesn’t fit well if you’re wanting to reach financial independence in around 10 years or less.
As I’ve said before, with a good savings rate you don’t need leverage to build wealth or retire early.
Using low cost debt can definitely be useful in long term wealth-building. And I remember the feeling of wanting to juice progress as much as possible, so I would definitely consider using leverage to increase our share portfolio.
But I also see the appeal in running your finances in a more relaxed way with no debt whatsoever. Borrowing to invest is taking on more risk, which may or may not pay off depending on your investments and your timeframe.
Whether it fits with how you want to invest… that’s for you to decide.
Would you consider using low cost debt to invest in shares? Let me know in the comments. And if you already have, tell me how the experience has been 🙂
Home loan recommendation: If you’d like help with anything home loan related, like accessing equity or refinancing, check out my personal mortgage broker – More Than Mortgages. I’ve worked with Deanna and her team for many years and they’ve been fantastic.
Note: this blog may receive a referral fee if you use More Than Mortgages. I only recommend things I use myself and genuinely believe in.