What is an Investment Loan?
An investment loan provides a lump sum of money that can be used to buy assets.
These assets must have the potential to increase in value over time or generate income.
At the time of the loan’s maturity, you repay the full loan amount plus applicable interest, and hopefully have seen an increase in your portfolio through the funds that you used to buy new assets.
One of the most common ways to obtain an investment loan is to use your Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA) as collateral.
This allows you to contribute to your plan and increase your assets.
You can also take out a line of credit or mortgage on real estate assets to fund your chosen investments.
Alternatively, you can borrow funds against financial assets you already hold in an investment account.
Generally, qualifying financial investments that can be used as collateral include Canadian dollar assets and U.S.
Treasury securities in U.S. dollars.
The Bank of Canada provides a specific list here.
Benefits of an Investment Loan
Using your existing assets to invest can offer benefits if you are in a position to do so and understand the risks.
Here are the most notable benefits of an investment loan:
- Compounding returns – leveraging your assets can increase your profits without using your own funds. Your existing investments continue to earn while you grow your portfolio.
- Option to pay interest only – some investment loans give you the option to pay interest only, with the principal due at maturity. This may be a benefit if you’re planning on selling an investment property or business soon.
- No prepayment penalty – pay off a portion or the entirety of your loan at any time without penalization.
- Non-registered investment interest deduction – interest paid to buy stocks, bonds, mutual funds, exchange-traded funds, and other securities outside of registered accounts qualify for an income tax deduction. Rental property and starting a business may also qualify.
- Diversify credit mix – an investment loan against an RRSP, TFSA, or non-registered account could help those with a limited payment history increase the diversity of their credit. Payment history accounts for 35% of your overall credit score.
- Potential tax benefits – maximizing TFSA and RRSP contributions can reduce your tax burden. Dividends paid on the stock of Canadian corporations also enjoy lower tax rates.
- Potential capital gains benefits – only 50% of capital gains are subject to tax. Tax isn’t paid until investments are sold.
Risks of Borrowing Money to Invest
Borrowing money always comes with risks and investment loans are no exception.
The following are the most notable:
- Risky for novice investors – these loans carry medium to high risk, depending on the terms and lender. There’s no guarantee your investments will increase in value. Plus, you must repay the loan principal and interest even if the value of your investments decline.
- You could lose your collateral or increase indebtedness– if you are unable to repay your loan, your lender may sell collateral to recoup their money. Interest can also be rolled into your loan balance, increasing your loan balance.
- Long-term investments are vulnerable to interest rate changes – higher interest rates cut into your investment gains.
- Many investment loans require a long-term commitment and therefore may not suit those nearing retirement.
- TFSA & RRSP interest is not tax-deductible – money borrowed to invest in registered accounts is not tax-deductible, because the income earned is not taxable income.
- Over-borrowing – borrowers can create a higher debt load than their income outside of what their current investment portfolio can bear.
- Additional costs – borrowing can include costs to buy or sell investments, management fees, advisor fees, and administrative fees.
What Qualifies as an Investment Loan?
Basically, you can borrow to invest in most assets that have potential to grow in value (appreciate) over time.
These include stocks, bonds, mutual funds, ETFs, rental properties, or even a new business.
Investment loans are not meant for assets that depreciate over time, such as machines, vehicles, primary residences, computers, and other technology.
Interest paid on investment loans backed by an RRSP or TFSA are not tax-deductible since they are tax-sheltered investments.
Frequently Asked Questions
- Is Investment Loan Interest Tax-Deductible?
That depends on what collateral backs your loan and how you use loan funds.
The interest paid on money borrowed to invest in a registered account such as an RRSP or TFSA is not tax-deductible. However, interest paid on qualified non-registered investments may be.
Nonetheless, you would not qualify for a tax deduction if you borrow money and then decide to use the funds for a personal purpose other than investing.
- How long is an investment loan?
That depends on the lender and the assets used for collateral.
TFSA and RRSP investment loans may be for as short as one year. However, most other investment loans are long-term. Many lenders require a commitment of at least 5 years, and sometimes even longer.