In Part 3 on the series on Leverage we are going to look at a tax benefit of borrowing money to invest. (NOTE: This does not apply to RRSP loans.) I STRONGLY recommend reading Leverage Part 1 and Leverage Part 2 in the series as a refresher before reading this article.
When you borrow money to invest in a non-registered account (in other words, not an RRSP or other tax-sheltered account), you are allowed to write off the interest on the loan! Let’s make an analogy: you may have heard that if you were to borrow money from the bank to start your own small business you could write off the interest on that business loan. The reason for that is because the interest is a "cost of doing business" – i.e. you wouldn’t have that cost (the interest on the loan) if you didn’t have that small business. The same logic applies to loans used to purchase stocks and bonds in that you are taking on the loan in the expectation of making an income (same as with a small business!).
If you need to brush up on what a tax write off is, please refer to the post "What is a tax write off?" as we will now look at the effect on the leverage that Greg has (from Part I and II).
So, if you remember our friend Greg – he took out a loan to invest. The loan amount was $7,530.89 and the loan payments were $83.33/month. Of the $1000 in loan payments he makes in the first year, $432 is towards interest. This means he can write off $432. If we use a fictitious marginal tax rate of 50% then he gets $216 back at tax time for the first year. Now, since he is paying off the principal as he goes, the amount of interest for the second year of the loan will be less, and consequently the write off and tax refund will be less every year. According to my loan calculator, the total amount of interest he pays over 10 years is $2,469 – which if written of at 50% yields $1,234.50 in tax savings.
So let’s recap the total difference now between monthly savings and the leverage
Greg invests $83.33/month ($1000/yr) to his investment portfolio for 10 years, which returns 10% per year. He has $17,531 at the end of year 10.
Greg pays $83.33/month for 10 years to support an investment loan of $7,530.89 which after 10 years grows to $19,533. He has also written off $2,469 in interest costs which when multiplied by his marginal tax rate of 50% yields him a tax savings of $1,234.50. Add this to $19,533 and he has $20,767.50 at the end of year 10.
So whereas before, the leverage produced a net difference of +$2000, now the net difference is +$3200 after factoring in the ability to write off the interest on an investment loan.
Remember this example is using a positive rate of return of 10% and it is possible to have lower, negative or higher rates of return over 10 years. This post is just meant to illustrate the benefit of interest deductibility on an investment loan.
Part 4 of Leveraging will discuss the "interest-only" version of investment loans – if you thought we have been on a wild ride so far – "you ain’t seen nothing yet"! "Interest-only" loans magnify even further the potential risk and reward… stay tuned!