Nothing polarizes the personal finance community like whether you should take on debt to invest. I’m usually quite debt averse, but I’m not completely against it. It can be used to gain wealth in a controlled manner if necessary. I’m not really a black or white kind of person, but I have been thinking whether I should borrow to invest in a bear market should I run out of cash to invest. It is undeniable that we are in the middle of a recession in Canada and the lack of earnings will be very apparent soon.
Here are a few reasons why you might want to borrow to invest in a bear market, and a few reasons to stay away.
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Reasons Why You Might Want to Borrow in a Bear Market
Low Borrowing Costs
Right now, the cost of borrowing is very low. The Canadian government kept slashing and slashing the key interest rate. At the end of March 2020, The Bank of Canada slashed its key interest rate rate to 0.25%. The Prime Rate is 2.45%.
As of mid-April, it costs only 2.45% interest amount (some big banks are offering the bank Prime Rate offer on a line of credit) to borrow money to invest and you can get a 7% annual dividend yield on a high quality Canadian dividend bank stock that has been paying dividends for many many years and is relatively low volatility, it’s almost a no brainer.
The Interest is Tax Deductible
One of the big draws (for me at least) is that when you are borrowing to invest in a taxable account, the interest costs from borrowing money to invest in an asset that yields income is tax deductible. According to Taxtips.ca, you can deduct interest and carrying charges to earn income from Canadian and foreign investments such as stocks and bonds.
The key is that the income must be interest or dividends, capital gains don’t count. Then you can take that money that you saved on taxes and reinvest it into your portfolio. This is strategy is quite popular for those that use their HELOCs, in the Smith Maneuvre. Million Dollar Journey has used this strategy very well to reach financial independence.
To do this, you enter the interest expenses as carrying charges and interest expenses on Schedule 4 of your tax return and it will show up line 221. This can reduce the cost of borrowing to invest during a bear market even further, and reduce the risk further.
If you are in a high marginal tax bracket, even better. More savings on taxes.
You’ve Run Out of Room in Your Registered Accounts
If you have run out of TFSA contribution room and RRSP contribution room for investing, congratulations. If you choose to also invest in your non-registered accounts, as mentioned, even better since the interest is tax deductible.
Some people borrow to invest in order to top up their RRSP, but there are a few more things to consider before doing that. Get Smarter About Money says that if your marginal rate is low, the amount you save with a tax refund might not be worth borrowing to invest.
The interest costs are not tax deductible on a registered account like a TFSA or RRSP.
You’ve Used Up Most of Your Cash Pile… But Can Still Pay Off What You Borrow
You made the conservative move and were not 100% invested in the stock market. You had cash savings ready for times like these. However, you’ve used up a lot of your cash savings when the market started crashing (well, you’ve used up most of it). If the market is still in the deep red and the companies are still great companies, and you have a long horizon ahead of you before retirement, it may be tempting to borrow to invest during a bear market.
The caveat is to decrease the risk of borrowing to invest, you still have cash left to pay off what you borrow if push comes to shove.
Reasons Why You Should Avoid Borrowing in a Bear Market
It Can Be Very Risky
Investing in a bear market can be very risky. You don’t know where the bottom is. There’s no way to time the market. You think you might know where the market is headed and whether we’ve hit bottom yet, but Charlie Munger doesn’t even know, so you probably don’t either.
You should have a long time horizon ahead and it’s probably not a good idea to do this in the last few years before you plan to early retire.
You’re Already Over Leveraged
If anything, this recession showed us that nothing is safe and that debt is bad especially when you have no means to pay it. In a recent poll shared by The Globe and Mail, only 50% of home owners in Vancouver plan to pay for next month’s mortgage payment.
If you think using a HELOC is safe, you might not know that the banks can request you to pay back the money they lend you in the HELOC. The Canadian banks are in control, not you. This Globe and Mail article shows that the banks and lenders can increase your interest rate, lower your credit limit, recall your HELOC, and change your payment terms.
If you have mortgage debt from your primary residence, financing debt from your car loan, another mortgage debt on your rental property, and student loans, you are probably over leveraged and adding debt to invest would be very risky.
Dividends Aren’t Safe
Although dividends are like ocean waves and I consider them very safe, dividends are not 100% fool proof. Recently, one of the dividend stocks in my portfolio, The Keg (a Canadian steakhouse restaurant), slashed their dividend by 63%. This makes sense since their restaurants were closed and there is no revenue being generated.
These are unprecedented times- the economy’s greatest asset, people, are unable to work and unable to be productive. Earnings are going to be missed, there is no income being generated. Even though companies try to please the shareholders as much as they possibly can, when there is no income being generated, dividends, which are normally considered safe haven income for investors, do inevitably get cut.
The Safest Way to Borrow in a Bear Market
What is the safest way to borrow in a bear market? Well, it’s not borrowing on margin. I would not borrow to invest on margin since the costs of investing on margin can be quite high- for Questrade, it is prime + 2.50-3.5%.
Personally, I have not borrowed to invest yet in this bear market but I am not going to rule it out. I would get a line of credit for investing purposes after talking to my bank. It would be easier to track this for the cost of borrowing as well if it was itemized in a bank account statement compared to margin in a brokerage. I still have cash to deploy but when I get low, I may consider borrowing to invest if the market is still doing poorly and dividend yields of safe dividend paying stocks such as Canadian banks or utilities are still high.
My plan is that I would save my emergency fund and have 1-2 years of living expenses still available so I can raid the emergency fund to pay off the debt used to invest if needed. I’d probably keep around $40,000 to $50,000 available in cash. Cash is king and it is even more evident why cash is king during times like these.
Another thing that you would want buffed up and in good shape when you are borrowing is your credit score.
Building your wealth while using someone’s else’s money can be a key way to grow your wealth. After all, Liquid from Freedom 35 Blog has achieved it, becoming a millionaire within 10 years by borrowing to invest in farm land and in equities. Though borrowing to invest is definitely not for everybody. If you have trouble going to sleep at night as it is, it is probably not for you.
Would you borrow to invest in a bear market?
What situations or scenarios would make you feel more comfortable to do so?
GYM is a 30 something millennial interested in achieving financial freedom through disciplined saving, dividend and ETF investing, and living a minimalist lifestyle. Before you go, check out my recommendations page of financial tools I use to save and invest money. Don’t forget to subscribe for blog updates, a free dividend yield spreadsheet, and the free Young Money Bootcamp eCourse.