By Jason Heath, CFP on January 15, 2024
Estimated reading time: 5 minutes

Should you sell investments at a loss to pay off debt?

By Jason Heath, CFP on January 15, 2024
Estimated reading time: 5 minutes

When paying a high interest rate on debt, does it make sense to sell investments that have fallen before their value has been recouped?

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I invested $60,000 for my son in ETFs on my own. Then the market crashed, and he needed his money for a condo closing. I had to borrow from my HELOC to return his money and am paying close to $400 in interest each month. If I sold the ETFs, they would have been at a loss. Should I just hang in there till the ETFs recuperate, or do something different?

—Ruth

Selling investments to pay off debt

First, I want to acknowledge the risks of investing money you need over a short time horizon into stocks. This is not a criticism, Ruth, as much as it is a lesson for others.

The S&P 500 has had positive annual returns about three quarters of the time over the past 100 years. That means there is a decent chance you may invest money in stocks and earn a positive return over a one-year period. But there is also a one in four chance the investments decline. Diversification reduces risk and increases the likelihood of success.

If you invest in a couple of stocks as opposed to a diversified portfolio, there is an even higher chance of losing money.

2022 was also a good example of how even “safe” investments can lose money. A typical Canadian bond exchange-traded fund (ETF) or mutual fund that tracked the FTSE Canada Universe Bond Index last year would have lost about 12%. Bonds got hammered because interest rates went up and there is an inverse relationship between interest rates and bond market prices.

How well do your investments need to perform?

Regardless of how you got where you are, Ruth, the key question is, what should you do now? The ETFs you bought are down in value and your interest rate on your line of credit is way up. You are probably paying 7.45% to 7.95% interest on your line of credit (prime plus 0.5% to 1%).

In order to pay your assumed interest rate of 7.45% to 7.95%, you probably need to earn nearly 10% on your ETFs. The math works like this. If your ETFs earn 10%, you will have to pay tax on the dividend and interest portion, which may be 2% to 4% of the return. That will reduce your return by 1% to 2% after tax. Because the values have declined, you will not have capital gains tax to pay if you sell.

Over the next couple years, might you earn 9% per year on the ETFs? Maybe, but I would not count on it. Will the interest rate for your line of credit rise, causing the threshold you need to earn to be higher, or will it fall, meaning a lower investment return threshold to come out ahead? That’s difficult to say as well.

Your decision may only be a compelling one if either stocks or interest rates go way up or way down. In a middle-of-the-road scenario, Ruth, the choice you make may be much less compelling. So, consider this as you contemplate your stress level with the current arrangement.

When should you consider selling?

One thing I would discourage you from doing is using the original investment amount as the number to get back to before you consider selling. It can be detrimental to fixate on recouping a loss before you sell an investment. It may be more empowering to look at it from another perspective.

You could sell those ETFs with the push of a button and turn them into cash. It may cost you $10 or less in commissions at a discount brokerage, Ruth. If you had that same amount of money in cash, would you buy those same ETFs today—which, we agree, you could do instantly and easily? If yes, perhaps you stay invested. If no, consider selling.

If your plan is to stay invested and wait it out, know that it may be a matter of months, or it could take a few years, depending on the ETFs you own and how markets perform.

Watch for tax deductions and superficial losses

You could consider selling the ETFs and paying off the line of credit and then borrowing the money back to reinvest. The reason for considering this is that the interest will become tax deductible. Right now, the interest is not tax deductible because you borrowed the money to give to your son (for personal use). If you borrow the money to invest in ETFs (for investment purposes), the interest will be tax deductible to you. The after-tax cost of the interest may be cut in half due to tax savings on the deductions.

One word of caution is that if you sell your ETFs at a loss and repurchase the identical ETFs within 30 days, you cannot claim the capital loss on your tax return. Instead, it is a superficial loss as if you never sold the investment in the first place. This may not matter if you have no other capital gains to offset in the current year or the three previous years. Capital losses can only be claimed against capital gains.

If you did want to claim the capital loss for the current year or carry it back to a previous year, consider selling the ETFs and repurchasing similar ETFs. This could be accomplished by selling an ETF and buying an ETF that tracks a similar index from another ETF provider.

If you decide to hold off until the ETFs recover, Ruth, just remember that this could take a few years. Hopefully it won’t, but stocks can be volatile and risky over a short time horizon. Over the long run, they are a great way to build and maintain wealth for people who do not have any immediate needs for the money or who only need to make small withdrawals. When an investor plans to withdraw most or all of an investment over a time horizon of five years or less, there is always a risk they may be selling at a loss if they have exposure to risky or volatile assets like stocks..

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About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.