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.”
It is important not to skip this step, as it’s crucial for you to see what are your capacities at this stage:
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.
While the investment loan increases your portfolios, it can also be risky especially when the market prices rise.
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:
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.
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.
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.
John has been a freelance writer for the past 3 years. He worked for 4 years as a Mortgage Consultant and a Financial Advisor. He also worked for 2 years as a Loan Manager for a medium sized company that handled bad credit loans, car loans and personal loans. We are excited to have John in our team!
John writes about Finance, Philosophy, Money Saving Tips and much more. He is a proud Member of Financial Advisers Australia (AFA) and has Cert IV in Financial Services.