Ask any financial advisor if you should borrow to invest in a basket of equities and 99.9% (0.1% margin of error) of them would tell you no. There are loads of reasons why you shouldn’t.
But what if you did borrow to invest in equities? I am going to look at an investment of €250,000 in equities, growing at 5% per annum and paying a dividend of 2% per annum. As I am investing in direct equities, I will be paying CGT at 33% at the end.
The big advantage of borrowing to invest is that you can get a large lump sum of money working for you from day one. If you let your money grow over 25 years, you will have a whopping €846,588 at the end of the term. After CGT is paid, you realise €650,133.
You also get a higher dividend as you are getting 2% of the full €250,000 from the beginning. And as the value of the investment grows, so does the dividend payout. What starts as a dividend payout of €5,000, ends as a payout of €14,306. A total of €221,144 is paid in dividends.
The debt is always there. At an fixed interest rate of 3.22% over 25 years, your repayments are €1,214 per month. Even offsetting the net dividends you will receive, it will cost you €856 a month to service the loan.
Dividends are liable to income tax, PRSI and USC. It appears that you cannot offset dividend income against interest paid on the loan. According to PwC:
The principal non-business expenses that may be deducted are interest on loans for investments in rental properties, certain private trading companies and partnerships, subject to certain conditions.
As we are investing in publicly traded companies, I am going to assume that interest cannot be offset. If you are paying tax at the higher rate, you can expect to pay 52% in taxes on your dividends each year. If you are paying tax at the lower rate, you can expect to pay taxes at 28.5%. If paying tax at the higher rate, you will net €106,629.
At the end of the 25 years term, with your loan repaid fully, you will still make a net gain of €393,373 from your investment.
There is also longevity risk with the companies that you invest in. Will the top companies today still be around in 25 years time? In 1992, General Electric was the biggest company in the S&P500. It is now in the toilet and the company is being broken up. The world’s biggest company, Apple, was trading at $0.19 25 years ago (trading at $174.55 today). Would you have bought Apple 25 years ago? Don’t think you know who the biggest companies will be in 25 years time. It may not have been started yet.
The debt will always be there. Even if paying off capital and interest, a stock market crash can see you in negative equity very easily. Even worse is if you have an interest only loan and the capital never reduces. This merely increases your risk exposure.
Say you put in €10,000 a year for 25 years instead?
The first €10,000 is invested for 25 years, the second €10,000 for 24 years etc. You will have €501,235 at the end of the term. After paying CGT, you will receive €418,747.
Your dividends will also be lower as you are starting off with 2% of €10,000 instead of €250,000. At the end, you will have received €96,034 gross or €46,096 net if paying the top rate of tax.
But there is no debt to be repaid and no cost of debt. You can afford to invest this money and not have the exposure of being in negative equity at any time, because there is no debt.
When we compare the net income from the two scenarios, investing €10,000 a year will net you €464,843 at the end when you include dividends. Whereas if you borrowed, you will have €756,762 at the end. But you would have paid €363,389 in debt repayments, reducing your return to €393,373. So you would be better off to the tune of €71,470 if you didn’t borrow.
In this scenario, there is no advantage to borrowing and you will in fact be worse off. And that is before you take into account the 25 obligation you are taking on of repaying debt and managing an investment account.
Steven Barrett
22 August 2022