4 reasons not to borrow to invest in stocks

All investors, even conservative retirees, should hold some top-quality high-yield stocks that regularly raise their dividends. But generally speaking, it’s a good idea to use your own cash and refrain from investing borrowed money.

The Federal Reserve (the U.S. central bank) plans to gradually raise its federal funds rate. Since the federal funds rate sets the direction of interest rates across the U.S., we expect a gradually-rising interest rate environment. Even so, at present the federal funds rate is low. According to the Federal Reserve Bank of St. Louis, the observed rate in August was only 0.4 per cent.

A friend now wants to take advantage of low interest rates. He plans to take out a $50,000 loan and use it to buy high-quality dividend-paying stocks. That is, our friend plans to use leverage to magnify his gains. We pointed out, however, that leverage could magnify his losses if things go badly.

Unexpected rate changes are less likely

Our friend hesitated to pursue this strategy before. He feared a quick succession of increase in interest rates, which could hurt stock prices and cost him money. But with interest rates likely to rise only gradually, he has lost this fear. Also, our friend says that with the U.S. Federal Reserve updating its advice every three months or so, he’ll know if rates will jump. If so, he’ll sell and pay off the loan.

Our friend is debt free. He paid off his student loan back in 1989. Our friend paid off his mortgage in 2005. And he pays off his credit card bills in full each month—thereby avoiding paying interest at rates he calls ‘usurious’. Given his debt-free status, our friend expects to be able to borrow at the current prime rate of less than three per cent. He’s even willing to use a HELOC (or home equity line of credit) if the collateral would further reduce his interest rate.

More cash plus income tax write-offs

Our friend plans to buy high-quality stocks. He intends to focus on companies that pay attractive dividends and regularly raise them. Our friend expects to earn more cash from his dividends than he pays in interest to the bank.

Our friend plans to buy the stocks with an ‘interest-only’ loan. That is, he’ll pay only the interest part of the loan. Unlike, say, a mortgage, there’s no need to repay the principal until he chooses to do so. Our friend points out that since he will borrow the money to buy dividend-paying stocks, he can use the interest payments to reduce his tax bill. The interest is what’s known as a ‘carrying charge’ on the income tax return he’ll file in April of 2017.

We also told our friend that the Canadian consumer price index was up by 1.3 per cent in the year to July 31, 2016. That is, the principal he owes will effectively shrink by the inflation rate.

Our friend is enthusiastic about borrowing to invest. He says: “I’ll be getting paid to hold stocks that are going to go up.” But we told our friend about four potential risks he faces.

Interest rates are low due to economic risk

First, interest rates are being kept low partly to reduce the risks to the economy. The global economy is growing far more slowly than before the latest financial crisis and recession. The Euro-Zone economy, for instance, is expected to grow by only 1.5 per cent this. In 2017, its growth rate is expected to fall to just 1.2 per cent. Japan is expected to grow by only 0.5 per cent this year and 0.8 per cent in 2017. The economies of Russia and Brazil are shrinking. In a worst-case scenario, our friend could suffer major losses. His debt, however, would still remain.

Unexpected events quickly affect stocks

Second, if the Federal Reserve indicates that it may raise interest rates faster than originally expected, stock prices are likely to fall immediately. The chances are that this would reduce our friend’s gain or deepen his loss.

A third risk is that if our friend loses his job, he might find it difficult to make the interest payments on the loan. Our friend could sell the stocks, but if they’re down, he’ll have lost money. Fortunately, our friend’s wife earns a good salary. So this third risk doesn’t really apply to our friend.

A fourth risk is that investing borrowed money can lead to poorer investment decisions. For instance, investing borrowed money can indicate a certain impatience at how long it takes to ‘get rich’. Such impatience could lead our friend to sell before he has given his stocks a fair chance to perform. Our friend has, in the past, made more money for his broker than for himself.

We believe that even conservative retirees should hold some top-quality high-yield stocks that regularly raise their dividends. But generally speaking, it’s a good idea to use your own cash and refrain from investing borrowed money.

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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