KT explains: Do you have to borrow money to invest? – New
Dubai – The price of cryptocurrency has since fallen by almost half.
Do you have to borrow money to invest? While this may go against the established financial wisdom that suggests debt is generally bad, some people want to use it to build wealth.
Dave R., for example, made some intellectually rational arguments earlier this year to take advantage of low interest rates and use debt to build wealth. He mortgaged his house fully paid off and invested some $ 200,000 in Bitcoin.
The price of the cryptocurrency has since dropped to almost half, from $ 58,000 to around $ 34,000 now.
âI lost my job in March of this year and have been unemployed ever since. I have some cash to support myself and honor my bank commitments for at least six months, but I understand that if I can’t find a job by September of this year, this bet could turn out badly â, Dave said.
The attraction of low interest rates
Generally, it is best to invest in US dollar assets if the investor is borrowing in the UAE, said Vijay Valecha, chief investment officer at Century Financial.
âInterest rates in the UAE are low because the currency is pegged to the US dollar, and many might be tempted to borrow from here and invest in high yielding assets back home. However, in practice, this is a dangerous strategy, âhe warned.
Investors who take a UAE dirham loan and invest in another currency should remember that they are selling the US dollar and buying another currency. Therefore, investing in the same currency as the loan will help reduce currency risk.
However, there are a lot of risks with this strategy. Investors who run the risk of tight liquidity should never take advantage of leverage.
Invest in the countries of origin
It’s not a good idea, says Valecha. âThe UAE dirham is pegged to the dollar, so from a currency perspective, the dollar value of the loan will be stable. This is not the case with emerging markets. If their currency depreciates, the value of the asset purchased with a loan decreases. It doesn’t make economic sense. This is especially true in the current scenario where the US Federal Reserve withdraws its monetary stimulus and is expected to raise interest rates in 2023. These developments should lead to a strong US dollar, and it is not advisable to invest in emerging assets with a loan from the United Arab Emirates.
Vishal Dhawan, CEO of Plan Ahead, added: âLeverage is useful when asset returns rise, but can work against you significantly when asset prices correct, as seen several times in the past. Additionally, when you invest in a currency other than the currency you are borrowing in, you could also be exposed to the risk of currency fluctuations working against you. Therefore, it is ideal to avoid using leverage for investing.
The leverage not only helps you on your way up, but it definitely makes the pain on the descent worse.
âThe use of personal loans in a situation where employment uncertainty is high should be avoided because there is the additional risk that a loan will have to be repaid against an asset that could have suffered a price correction. We have to remember that very often during major asset corrections, employment uncertainty also intensifies, âDhawan said.
How to assess the risk
Personal debt is a very real source of stress, and if it’s not handled well it can get out of hand. One of the best ways to assess your repayment capacity is to take a stress test, something similar to a bank stress test.
A bank stress test is an analysis conducted under what-if scenarios to determine whether a bank has enough capital to withstand a negative economic shock.
At an individual level, this may mean assessing your ability to repay or honor your financial commitments in the event of job loss or declining income. If you can continue to easily repay your loan if the costs have doubled or tripled, then you are fine. But if the doubling of the cost of servicing your debt is causing you difficulty, you need to be careful.
Taking on more debt to build assets can make it vulnerable to several shocks, interest rates and declining income.
âUnderstand the characteristics of the asset class you are investing in, for example, stocks as an asset class generate returns over longer periods of time. Therefore, using short-term upward movements to invest can expose you to recency bias which can adversely affect your financial health. Also, only borrow if you have surplus available to repay if your investments aren’t performing as you expected, and don’t have to panic just to pay off the loan, âDhawan said.
Debt is not a shortcut to wealth and should not be viewed as such. Yet we are increasingly accepting at a rapid rate through loans, credit cards, telephone contracts, buy-it-now and pay-later schemes, and in many cases personal loans for investments. in shares or real estate.
Dealing with the fallout from debt can be very difficult. So even if the lenders are willing to offer you more money, that doesn’t mean you should take it. Avoid excessive leverage.