Recently, I was working with someone close to me to analyze an investment opportunity. Let’s call this person Joe so that I don’t reveal his identity just in case he reads this post and doesn’t like what I have shared. Not everyone is open to sharing financial information or personal stories like me and I totally respect other people’s privacy. The reason that I wanted to share this post is that it’s a topic that I am deeply passionate about. I want every reader to take a step back and ask him/herself, would you borrow money to invest if you have the opportunity?
A couple of months ago, Joe’s father had just sold his house and he wanted to help Joe buy a property to build some assets and get into the sizzling hot Greater Toronto Area (GTA) real estate market. I was enlisted by Joe’s father as the trusted Realtor and financial coach to guide Joe through the home buying process as Joe is a first time home buyer. Within a short couple of weeks, I was able to find a property that suits both of Joe’s and his father’s requirements. Now, the question is, “What should they do with the financing of the new property?”
The Investment Opportunity
Joe’s father is a very caring and generous individual as he is willing to pay for the whole purchase of Joe’s new house. When this fortunate financial situation arises, there is an investment opportunity for Joe to diversify his assets into the stock market. With a great deal of financial flexibility, I recommended Joe to first pay off the purchase of the house and then borrow money with a mortgage loan to invest in the stock market to build wealth for the future.
When Joe has a mortgage-free home and borrows money to invest via a mortgage loan, the interest that he pays on the loan is tax deductible. He can use the interest cost to lower his income tax as he uses the proceed of the loan to earn income. This is totally legal under the Canadian tax law. On the other hand, if Joe were to put a 70% down payment on the house, got a mortgage for the rest of the 30% and used the remaining money to invest, the interest on the mortgage won’t be tax deductible.
What’s the difference between the two methods? In terms of net cash inflow and outflow for Joe, there is no difference. The difference is in how the Canada Revenue Agency (CRA) categorize the investment money. It’s the 30% of the money that Joe did not use to pay off his house and used it to invest instead. Since that 30% was not borrowed money, there is no interest cost to lower his income. In addition, if the 30% of the money was a loan from Joe’s father, then Joe can use the interest that he paid to his father to lower his income tax. However, Joe’s father now has to count the interest payment from Joe as income and will have to pay tax on the interest income. Hence, a simple structuring of the flow of money can greatly affect how much income tax Joe pays.
The Mortgage Terms
Since the cash proceed from the mortgage is used for investment, the goal is to prolong the amortization period of the loan as much as possible to keep the monthly payments low. Also, locking in the mortgage at a fixed rate for five years will provide cash outflow certainty and keep the payments consistent for that period. I was able to obtain a quote at one of the five big banks at an annual rate of 2.54%, fixed for a five-year term and amortized over a 30 year period. The total monthly mortgage payment for both interest and principle comes to $396.51 to borrow $100,000.
The Investment Portfolio
Last year, I had written a post about how I got paid when I borrowed money from the bank with a portfolio constructed from a list of Canadian dividend paying stocks. For Joe’s portfolio, I constructed a similar list of Canadian dividend paying stocks with a bit of exposure to the U.S. market through an ETF that mirrors the S&P 500 index (XSP). This portfolio’s dividend yield is about 4.08% based on the purchase price on June 01, 2017. On average, this portfolio will receive about $339.60 in dividend payments per month.
Sourced from TaxTips: Ontario Marginal Tax Rates
Income Tax Considerations
If you’ve been reading my blog, you would know that income tax is always at the forefront of any discussion when I am evaluating an investment. Since Joe lives in the province of Ontario, let’s assume that he’s making a modest annual salary of over $45,916 up to $74,313 (the third lowest marginal tax bracket). Since he paid a total of $2,500.36 in interest for the first year, he’ll receive a tax refund of $741.44 = ($2500.63 * 0.2965) based on his current marginal tax rate. Joe also has to pay tax on the dividend income too. He’ll have to pay $274.79 = ($3944.14 * 0.0639 + $131.05 * 0.1737) based on his current marginal tax rate (I have split the tax calculation as the dividend received from U.S. Stocks do not receive the same tax incentive as Canadian dividends). Assuming that the dividend income and the interest cost do not move Joe’s taxable income into a higher or lower tax bracket.
The Cash Flow
For now, for simplicity sake, let’s just assume that the average monthly dividend payments from the stocks are available at the end of the month and ready to be used for the mortgage payments. With simple math, the cash outflow is $56.91 = ($339.60 – $396.51) per month. Hence, to borrow $100,000 for investment, Joe will have to have a forced saving of $682.93 = (12 * $56.91) per year. However, when we factor in the cash flow for the tax refund and the dividend income tax payable, Joe only need to pay $216.29 = (-$682.93 + $741.44 – $274.79) out of his pocket annually.
The Overall Financial Benefit
The overall financial benefit for Joe is equal to the mortgage principle paid plus the tax refund for the mortgage interest minus the forced saving amount and minus the income tax paid for dividends earned. On an annual basis, Joe makes approximately $2,041.20 = ($2257.49 + $741.44 – $682.93 – $274.79) just by borrow $100,000 to invest. For the duration of the first five years of the mortgage term, Joe makes approximately $10,206.00 = (5* $2,041.20). This does not include any potential dividend increases from the stocks and the potential capital appreciation of the stocks.
The Breakeven Analysis
Based on the overall financial analysis calculation, if the total value of Joe’s investment after five years is worth $88,000, then Joe will breakeven for this endeavour. He will have approximately $100,000 = ($88,000 + $10,206.00 + $12,000.00 * 0.1483) if he sold his investment at the end of five years and claim a tax refund of approximately $1,800 = ($12,000.00 * 0.1483). Hence, he’ll have a 12% safety cushion for this investment maneuver. He’ll only lose money if the value of his investment is less than $88,000 and he will make money if his investment value is more than $88,000 after five years.
The Ultimate Questions
Before Joe makes the decision to borrow money to invest, I asked him a couple of questions to get him thinking. Why are the majority of people waking up every morning to go to work? Isn’t it to earn money? What would you rather do, you work for money or have your money work for you?
Having A Financial Coach
Since Joe is pretty much a novice when it comes to investment, I wouldn’t recommend that he jumped into the financial market alone. That’s like throwing a sheep out in the woods with a vicious pack of wolves lurking around. With my financial background and investment experience, I offered to be his financial coach to guide and help him set up everything. In the short term, I’d hand hold him through all the steps, but in the long term, I’d prefer Joe to take over and be responsible for his own money.
My Two Cents
For now, I will not reveal what was Joe’s decision as I want my readers to put themselves in Joe’s shoes. If you were in Joe’s situation and have a similar opportunity, would you borrow money to invest? Or you would choose to live mortgage-free and continue to work for money?