Do you have to borrow money to invest?
Global stock markets have been broadly up in recent years (aside from the massive sell-offs in March), which may have heightened the temptation to borrow money to invest in the stock market.
The idea behind this strategy is that you aim to invest your money so that it grows at a higher rate than the interest you are paying on the loan you have taken out. And while mathematically it sounds like a good idea, it is not without risk. Here are a few things to consider first:
Am I going to do enough to pay off the loan?
Earning more money to pay off the loan is not as easy as it sounds. Christine Benz, director of personal finance at Morningstar, warns that investors should think carefully about what they can realistically earn from different types of investments. “In this case, there is a mismatch between a guaranteed bond (cost of borrowing) and return, which is uncertain regardless of where you invest unless you are in cash,” she says. “And with cash vehicles, you won’t come close to matching your borrowing costs. “
Interest rates are lower than they’ve ever been – the base UK interest rate is 0.1% – and that means borrowing is cheap, too. According to Moneyfacts, the average rate for a three-year personal loan of £ 5,000 is 7.4%, while you can borrow £ 10,000 over five years at 4.5%. But even if the interest rate on loans is lower than in the past, it is still a hurdle for an investor to overcome if he wants to generate returns beyond his interest payments.
This means that investing in safer asset classes like bonds is prohibited – not only do you have the potential to lose money, but you also might not earn enough to make up the loan. “The average yield decreases with bonds, so it can be unprofitable to do so. It really depends on what rate you can get, ”says Benz.
Another factor to consider when investing is cost: platform fees, ongoing fund charges, and stock trading costs all impact returns. We have already looked at how to reduce investment costs, but regardless, it still costs money to invest and it should be factored into your calculations.
What if I sell at the wrong time?
Stock markets tend to be more lucrative than bond markets, but with higher potential returns comes increased risk and volatility. As we saw in March 2020, the stock market can sell quickly and strongly, often with little to no warning.
Another complication is that stock market valuations are high today after a strong rally, further increasing the risk of borrowing to invest, Benz says. If your investments suffer a problematic drop because loan repayments won’t wait – although you may have the risk tolerance to wait for a market rebound, you’ll need to make sure you can meet your financial obligations in the meantime.
“This means you might be forced to sell an investment at the wrong time,” Benz explains. “It’s psychologically very difficult to sell your investment if you’ve lost money, but you might need the money to pay back. “
Are you comfortable?
Apart from math, investing is risk. Whether or not you are comfortable with debt is a personal matter, but there are always the possibility that you will lose the money you need to pay off that debt. “The debt is secured, and you balance that out by putting the money into something that is unsecured,” says Benz.
And while it’s obvious in hindsight that this strategy would have worked perfectly if you had taken a cheap loan and put the money on Amazon (AMZN) Apart from ten years ago, it’s almost impossible to predict and the chances of finding the next ten-bag are pretty low. Benz suggests thinking differently: “If you know that you have the money you would use to pay off a loan each month, why not put in place a regular investment plan and invest it each month instead? “
She adds, “Borrowing money to invest may be something that some sophisticated traders can do, but generally speaking, for small investors managing their accounts, it adds risk, complexity and cost – something. which I advise against. “