Should we borrow to invest with free money?

Borrowing to invest has been a personal finance strategy that has been used for generations, and is particularly interesting to think through in the current investment environment – after all, with money that is cheaper to borrow than it has ever been, and a vaccine that can move the world past COVID-19 seeming more likely by the day, surely borrowing to invest is a steal?

Have you missed your chance?

Borrowing to invest is, in a lot of ways, a market timing decision. It is about leveraging a person’s current financial position to make a significant investment now.

If markets have a great few years, then borrowing to invest will look like a wise decision. If markets struggle, then it will look like a poor decision. And, on that point, if you are thinking about a market timing decision to borrow and invest now, and expose a significant amount of capital to the sharemarket, can you be confident in your timing ability given that you didn’t take the chance to borrow and invest when the ASX200 was around 4500 points in late March this year? Instead, wanting to start now when markets are at 6500 points, 44 per cent higher.

An opportunity worth considering

That said, we should acknowledge the unique set of factors that exist in the Australian market that support a borrowing to invest strategy.

It is possible for a person to borrow against property with a five-year fixed interest rate of around 2.5 per cent per annum. Given that borrowing to invest is tax-deductible, the after-tax cost of borrowing for someone in the middle income tax bracket is less than 2 per cent per annum.

While the income from Australian shares has fallen, the reality is that the average market yield is still somewhere around 3 per cent, plus franking credits. That means borrowing to invest is a ‘cash flow positive’ option, making it a unique proposition.

Two arguments for borrowing to invest

A key benefit that is spruiked around borrowing to invest, whether it be to invest in property or Australian shares, is the tax benefit.

With sharemarket yields where they are at about 3 per cent per annum, franking credits having survived the 2019 election and tax-deductible interest costs, you end up with an interesting series of cash flows for an investor.

Let’s consider an investor who decides to borrow $100,000 to invest in Australian shares, and finances it through a mortgage with an interest rate of 2.5 per cent per annum fixed for five years (by choosing a fixed rate there is certainty about interest rate movements for some time – albeit that there does not seem to be much chance of interest rates moving upward in the short term).

They have to pay interest of $2,500 per annum on the loan.

They receive dividends of $3,000 per anuum.

Assuming their portfolio income is 70 per cent franked, they receive franking credits of $900 per annum.

Their tax situation is that the portfolio generates taxable income of $3,900 (the gross income from the shares), less the $2,500 of interest paid. This leaves them tax to be paid on $1,400 of income – assuming a tax rate of 32.5 per cent they have to pay $455 tax. However, they have a tax credit of $900 so will receive a tax refund from this activity of $445.

As a fairly attractive summary – the portfolio is both cash flow positive and tax positive.

A second argument in favour of starting a borrowing to invest strategy now is to look at the likely range of outcomes that might come from holding a portfolio of Australian shares for five years.

Vanguard’s digital index chart, found on their Australian website, shows that the average annual return from Australian shares from 1 Jan 1970 to the end of October 2021 has been 9.4 per cent per annum. This suggests that Australian shares as an asset class have been reliable in producing positive returns over longer periods – although a word of caution would be that at times it has taken longer than five years for sharemarkets to recover from downturns, including recently following the 2007 to 2009 Global Financial Crisis downturn.

Three arguments against borrowing to invest

The Reserve Bank of Australia (RBA) publishes a data series around the value of margin loans outstanding.

It tends to show that people who borrow to invest seem to have extraordinarily bad market timing ability. For example, between December 2005 and December 2007 margin loans outstanding double from $21 billion to $42 billion. We now know that December 2007 was a terrible time to borrow and invest, and the subsequent value of margin lending fell to below $15 billion by the start of 2012, where it stayed until the September 2019 quarter where it jumped from $11.1 billion in the June quarter to $17.5 billion (Sept 2019 quarter) and $17.9 billion by the December 2019 quarter – right before the COVID-19 downturn. Perhaps borrowing to invest is the ‘canary in the mine’ for people being greedy?

The current low rate of interest rates presents an important challenge for people thinking about borrowing to invest to consider.

Eventually, there will be a time when interest rates will rise to more normal levels. This is likely to have a double impact on people who have borrowed to invest.

They will face higher interest costs on their loan, as well as the possibility that returns from growth assets, including shares, might be below average in a rising interest rate environment.

A final argument against borrowing to invest is the exposure to a ‘black swan’ event. We can use the circumstances of the GFC or this COVID-19 downturn to illustrate this point.

At an individual level, a negative economic event might see someone with reduced personal income, perhaps they are only able to work part-time. The reduced income makes it much harder to keep up the repayments on their investment loan.

The investments themselves also produce less income because of the negative economic event. The investments also fall in value, making it impossible to sell them and repay the loan. Put together, this makes for a very challenging situation to manage.

Conclusion

Borrowing to invest will remain a popular personal finance strategy. And, let’s face it, if any of us had the courage to slip an extra $100,000 into the sharemarket when shares were at their lowest point eight months ago, our judgement would have been rewarded with more than $40,000 of capital gains as well as dividends.

Low interest rates and the continuation of relatively generous dividend income and franking credits from Australian shares make borrowing to invest an interesting strategy – although the evidence of the collectively poor market timing ability of people who borrow to invest, and the risk of a personal black swan event, make it a decision that should be accompanied by a thorough consideration of the risks.