This is part of a series on why borrowing to invest is rarely worthwhile.
Let’s imagine you remortgage your home to release £100,000 that you can repay over 20 years.
- You borrow at a great rate of 6%
- The loan is fixed for 20 years
- You invest in the index for its average 10% a year long-term returns
… and then you pocket the 4% difference, right?
Not so fast.
As we discussed in part one, using mortgage debt secured on your house is about the only way that borrowing to invest over the long-term is financially viable for most private investors.
But it’s still not a reason to do it.
For one thing, even if you have no problems repaying your 6% loan and the market delivers its average 10% annual return, you’re still not going to see all that 4% differential
You can knock off at least 0.3% a year off for costs, assuming you invest in an index fund or ETF that you never tinker with for two decades.
In reality, if you’re the risk-taking type who borrows to invest then you’ll also be the type who trades shares, which is very likely to increase your costs for poorer returns, according to academic research on over-trading.
Then there’s tax to consider. If you take any gains as income, you may pay income tax, further reducing your returns.
Equally, sitting on an income-free investment for 20 years will leave you with a hefty capital gains tax bill, although you can try to defuse it in the UK by using up your personal capital gains tax allowance every year.
The clean solution is to put your investment into a tax-free wrapper, which in the UK means an ISA or a SIPP.
But you can only put £7,200 into an ISA each year at the moment. (The ISA limit is rising to £10,200 from October for 50-year olds, and 2010 for the rest of us).
It will therefore be impossible to shelter our hypothetical £100,000 from tax using ISAs from day one. Instead, we’d have to sell a portion every year (defusing CGT) and move it into the ISA, which will reduce the taxes but increase costs.
What about using a SIPP?
Here the maximum lump sum is dependent on your annual income. You may have better luck with this route, but remember you can’t take money out of a SIPP until you retire — so you will need to be repaying your £100,000 loan out of earned income.
What if you’re unable to shelter your gains?
- In the UK, tax on dividend income depends on your income tax rate. There’s no more tax to pay if you’re a basic rate taxpayer, but higher rate taxpayers pay an effective rate of 25% on dividends. Additional tax rate payers (those who earn above £150,000 a year) pay an effective rate of 36.1%.
- Capital gains tax is 18% in the UK, which is fairly competitive, but there’s no taper relief — it’s a fixed flat rate.
(If you’re one of my overseas readers, check with your tax office for your own rates. There are some countries in the world where capital gains tax isn’t payable, which obviously changes things!)
What are we left with after tax and costs?
Our expected 10% return on our investments is down to 4% after interest repayments.
Let’s be generous and assume entry and exit costs and annual charges amount to 0.5% a year, since you don’t trade your portfolio.
Our return is now 3.5%, before tax.
Let’s also assume you invest in a product that delivers only capital gains (that’s another article in itself) so you’re not getting taxed on any income portion of your annual return.
Taking your final 18% UK CGT bill into account, by my maths you’re looking at a 2.87% a year return. Call it a 2.5% return if you’re sensibly cautious, or 3% if your glass is always full.
If you’re not already filling your tax-free shelter allowances, then you can reduce this final bill by moving a portion of your investment over each year.
You can also reduce the eventual bill by selling some of your investment each year to use up any annual capital gains tax allowance — but watch out for rules governing how long you must wait before buying back the same investment.
Any such trading will increase your costs, though.
Personally, I’m already using my full ISA allowance each year, I’m a higher rate taxpayer, and if I had a mortgage I’d be paying it down not increasing it!
The bottom line
Given the other risks with borrowing to invest that we’ll get into, I don’t really think returns of 2.5% to 3.0% per year after tax are worth chasing.
You’re paying off your debt with taxed earnings, while your gains on investing will be taxed.
Together with the cost of debt, tax and charges can easily wipe out most of your gains from borrowing to invest.
If you can shelter your investments from tax using the methods briefly discussed above, funding investment via long-term mortgage debt may be worthwhile, if you can stomach the other risks we’ll discuss in future posts.
However there’s certainly no shame in preferring the guaranteed return from paying off your mortgage as soon as possible. For most people it’s probably the better choice.