Debt can be a pressure point when it comes to personal finance conversations. It is not uncommon for the discussion to move to good debt versus bad debt. The simple differentiator I have heard is that debt with deductible interest is good and debt with non-deductible interest is bad. While this logic is easy to understand, the answer is not that simple.
But first, suitability
Borrowing to invest is not appropriate for everyone. If it’s suitable for clients to borrow to invest, make them aware of the risks and benefits associated with leveraged investing. Losses as well as gains may be magnified. Importantly, if the investment performs poorly, then the investment value may be less than the loan balance. Carrying debt adds additional risk, and the client’s capacity to pay may be harmed by unexpected financial hardships, such as a job loss.
Which debt is good?
Assuming this strategy is suitable, let’s explore the good-debt concept further. To do so, we will review three leveraged investing scenarios where a hypothetical investor funds an RRSP, TFSA or non-registered account with the proceeds from an investment loan (see Table 1).
In each case, $50,000 is borrowed at a 4% annual interest rate and the loan has a 10-year amortization. The proceeds will be used to invest in a diversified portfolio with a total return (income and capital appreciation) of 6% per annum. Our investor is in a 46% marginal tax bracket. For the taxable account, we assume that 25% of the total return is taxable annually, with an effective tax rate of 25% on that mix of taxable investment income (interest, dividends, capital gains). In all three scenarios, the loan will be fully paid off in 10 years or less.
In the taxable account, the investment portfolio would increase the investor’s income tax payable by $2,428 over the 10-year time horizon. When combined with the tax savings from the deductibility of the loan interest (see “A technical note”), the investor realizes a net tax savings of $2,210.
The TFSA only saves the investor that $2,428 of tax on the investment earnings, since the interest on the loan is not tax-deductible. (Loan interest is deductible when borrowing to invest to generate taxable investment income.)
The RRSP provides the largest tax savings, thanks to the tax deductibility of the RRSP contribution. When the refund of $23,000 is applied as a pre-payment to the loan, it also significantly reduces the interest cost relative to the other options. In addition, the RRSP loan can be paid off in less than five years thanks to the refund (reducing interest costs), while the other two (TFSA and non-registered) loans are paid off at the 10-year mark. At the end of the time horizon, but before the investments are liquidated, the RRSP provides the greatest financial benefit, followed by the TFSA and non-registered investment. This occurs despite the fact that the only “good” interest-deductible debt is the loan used to fund the non-registered account.
Redemptions and tax
It’s important to note that the after-tax amount of each investment will be impacted by when the investor decides to redeem the investment: all at once or partially over time. That decision is not directly related to the leveraged investing strategy, but it allows the investor to control how much tax is paid when the investments are redeemed. Regardless of the investor’s decision, RRSP redemptions will be subject to the highest rate of tax since they are fully taxable. The taxable account will only be taxable to the extent there is a capital gain upon redemption (half of which is taxable), though the investor will owe tax on any dividends or interest income earned throughout the time horizon. Lastly, the TFSA will not be taxed upon withdrawal.
When a borrowing-to-invest strategy is suitable for investors, it should fit within their investor and risk profile, encompassing both the investments chosen and the suitability of the loan. We should not simply conclude that good debt has tax-deductible interest. Good debt provides the most benefit above its costs that helps investors achieve their savings or wealth creation goals.
Table 1: Borrowing $50,000 to invest—three scenarios
|Net interest cost of loan||($4,617)||($10,083)||($10,083)|
|Ending pre-tax balance||$89,542||$89,542||$89,542|