With stock markets down significantly across the globe as a result of the novel coronavirus in a matter of a month, it’s tempting to think stock markets are on sale and that you need to take advantage of that. Most don’t have large amounts of cash lying around, so borrowing to invest is one way to access that cash.

There are two main ways of doing this:

  • Delaying debt payments (this could be through banks offers to delay mortgage payments, or forgoing additional mortgage pre-payments that otherwise would have occurred), or
  • Borrowing from a Line of Credit or other loans

When borrowing to invest, you take the additional risk of leverage. You have certain interest that must be paid, and you receive uncertain investment returns. Leverage is beneficial in a rising market – you earn a higher return than the interest you pay on the loan. In a declining market, owing interest expenses while losing value on your investments can lead to a downward spiral. This makes it imperative to be able to afford those short-term interest payments, regardless of what your investments are doing.

Interest rates have fallen significantly within the last month. The Bank of Canada target rate now stands at 0.25% compared to 1.75% at the beginning of March. While interest rates have fallen, expected returns on stocks have risen as a result of the decline in market values. This makes investing more attractive and paying off debt less attractive compared to two months ago, but we need a framework to compare the long-term expectations of these two options objectively.

Paying off debt (like a mortgage) can be viewed as investing in a guaranteed fixed income investment. The interest rate on the loan is our expected return. For uncertain investment returns, we need to look at the long-term expected returns, but adjust those for risk, taxes, and fees.

We’ll review two examples:

Example 1: Delay a mortgage prepayment of $10,000 to invest in a 60% Equity, 40% Fixed Income portfolio within a TFSA.

Major banks have a posted 5-year fixed mortgage rate of 2.94%, so we’ll use that as our mortgage interest rate. Paying off the mortgage will provide a guaranteed investment return of 2.94%.

PWL estimates that investing in a 60% Equity, 40% Fixed Income portfolio has an expected return of 5.14% as of March 31, 2020. However, we need to adjust that for risk and remove investment fees from that return. We get an adjusted expected return of 3.52%, which we can now compare to the 2.94% mortgage rate. You should expect to see a higher net worth if you invested rather than prepaid your mortgage.

Example 2: Borrow $10,000 from a Home Equity Line of Credit (HELOC) at 4.45% to invest in a 75% Equity, 25% Fixed Income portfolio in a non-registered account.

Similar to the previous example, we need to compare the guaranteed interest expense with the uncertain investment return. However, this time, we need to incorporate taxes. Borrowing to invest allows you to deduct the interest expense on the loan from the taxable investment return on the investments. We’ll assume that this individual is in the 43.41% tax bracket.

Therefore, the after-tax interest expense is 2.52% (=4.45%*(1-43.41%)). The gross expected return on a 75% Equity, 25% Fixed Income portfolio is 5.75%, however after accounting for risk, management and product fees, and taxes, the expected return drops to 2.25%. You’ll owe more on your HELOC than you can expect to receive in net investment returns. Regardless of their tax rate, at this interest expense, it only makes sense to borrow if this individual’s portfolio holds at least 90% equities.

A final cautionary note about borrowing concerns liquidity. Liquidity is a measure of how quickly you can access funds if you need to. Over the past few weeks we have seen periods when even investment grade bonds struggled to find buyers and some mortgage funds are suspending redemptions as they do not have sufficient cash to meet redemption requests. It is always worth remembering that lenders can be stressed and demand repayment just at the time when your investments become illiquid.

While expected returns on equities have increased and borrowing costs have decreased in the past month, borrowing to pile money into investments isn’t a sure-fire strategy when considering interest expenses, risk, fees, and taxes.