How Smart It Is To Borrow Money To Invest


Posted by John Loff / Dec 5, 2018 / 0 Comments / Posted in Personal Finance

Does it Make Sense to Borrow Money to Invest?
Borrowing to invest, commonly known as “gearing” can be beneficial and risky at the same time. Your returns increase when the markets rise but result in devastating losses when the markets fail.

You must be informed about the possible outcomes of the decision, and also be ready to take risks. You should use this strategy if the benefits outweigh the risks.

”The decision to borrow money to invest comes down to comparing the borrowing costs versus the possible investment returns,” mentioned S. Michael Sury, Executive Director at SIFIRM (@SIFIRM). “The transaction will make sense only when the expected returns exceed the cost of borrowing.”
 

Warning Borrowing to invest is risky. It should only be considered by the experienced investors only.

Questions to Ask Yourself Before Borrowing for the Purpose of Investing

It is important not to skip this step, as it’s crucial for you to see what are your capacities at this stage:

  • Do I have a secure source of income from other sources? For instance, is my salary enough to top up the debt if I get a margin call?
  • Is my marginal tax rate high to make most of the tax benefits?
  • I’m I fit for the long haul?
  • Is my plan flexible enough to accommodate personal changes such as a drop in income or having children?
  • Will I handle the stress should the investment perform poorly?
Keep in Mind Borrowing to invest is usually a long-term strategy which might take up to ten years.

What are the Benefits and the Risks of Borrowing to Invest?

Professional traders borrow money from lenders and brokers to invest in stocks and other exchange-traded funds, but the tactic can ruin investors who are not keen enough. Using your stock to purchase inventory or “borrowing on margin” is one thing, but getting a loan against your home is another.

Benefits

  • Some borrowers may allow you to use your excising collateral or shares. Doing this will increases your investment even without depositing additional cash.
  • You can create a more extensive portfolio as compared to when you were using your funds.
  • Allows you to manage concentration risks through portfolio diversification.

Risks

While the investment loan increases your portfolios, it can also be risky especially when the market prices rise.

  • The costs linked to interest may lower your profits. Interest rates can also change with time and increase your cost of servicing the loan.
  • Margin rates are subject to change. This may make you make an additional cash deposit at short notice. For instance, if you invested the loan in shares, your shares may be sold at a loss to repay the loan balance.

Managing the Risks Related to Investing Borrowed Money

According to Rob Williams, the Managing Director on Income Planning at Schwab Center for Financial Research (@schwabresearch), in order to avoid potential risks related to borrowing money for investments you should “Shop for the best terms based on your situation, go for the lowest rates you can find in that context, and use debt for the right purposes as part of your financial plan.”

So, how can you manage the risk associated with borrowing to invest? These strategies will help you to manage the margin loan risks:

  • Set a loan borrowing limit which you can comfortably pay and stick to it.
  • Check your LVR on a regular basis since the value of your investments can quickly change.
  • Keep your loan limits within a limit you can manage. You can achieve this by making regular payments.
Keep in Mind Make sure that your investments are diversified if you are borrowing to invest.
Diversification reduces your exposure to a single economic events and thus laves with fewer chances. It ensures that you don’t lose all your money if one of your sectors or business performs poorly or fails.

Investment advice

Above all, follow the decision which you are comfortable with. “Borrowing to invest is okay provided that you understand the risk you might encounter in the long run. However, if you are trying things in the market to see how they would be received, then I would advise you not to do it. That would be more of gambling, and not investing,” says Adam Mayers, an Investment and Personal Finance editor at Toronto star (@torontostar).

Any investment requires independent financial advice. If your advisor only recommends you to invest in the company they are working for, then that might not be the best investment. Look for an advisor who doesn’t have other interests and favors.


Experts Cited

Michael Sury Photo

 

Michael Sury is an Executive Director at Strategic Investors in Financial Innovation&Risk Management (@SIFIRM) and a lecturer at the University of Texas, Austin. He has also worked as finance lecturer at the University of San Diego State. Sury has received many scholarly and teaching accolades including the Seiden award at the DePaul University.

Adam Mayer Photo

 

Adam Mayer is an author and ghostwriter with well-rounded skills in economics. He is also a former personal finance and investment contributor of the Toronto star (@torontostar).

Rob Williams

 

Rob Williams is the Managing Director at Schwab Center for Financial Research (@Schwabresearch), whose area of expertise covers financial planning, retirement income & wealth management. His previous experience at Standard & Poor’s in the Public Finance division, along with the bachelor degree from Princeton University and an M.B.A. from the University of California, Berkeley make him a reference name in the domain of personal finance.


Works Cited

1 CNBC “Investing with borrowed money can be a big win — for some” https://www.cnbc.com/2018/01/24/investing-with-borrowed-money-can-win-big–for-some.html

2 boomerandecho.com “Borrowing To Invest: What The Experts Have To Say” https://boomerandecho.com/borrowing-to-invest-what-the-experts-have-to-say/

3 Investopedia “https://www.investopedia.com/ask/answers/09/take-out-loan-to-invest.asp” https://www.investopedia.com/ask/answers/09/take-out-loan-to-invest.asp

4 Charles SCHWAB “Borrow Smart: How to Use Debt Wisely” https://www.schwab.com/resource-center/insights/content/borrow-smart-how-to-use-debt-wisely

5 Money.USnews.Com “Borrowing to Invest Is Risky Business” https://money.usnews.com/investing/investing-101/articles/2017-10-06/borrowing-to-invest-is-risky-business

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