Borrowing money to invest – a.k.a. leveraging – is the classic case of an idea looking good on paper and too often turning out to be catastrophic in real life. This idea is very relevant in the current investor crazea round cryptocurrencies. Many people have felt the reality of a market drop when they have already taken out a second mortgage against their home to fund a cryptocurrency investment. The problem comes in when you need to handle these fluctuations!
Only the steadiest of investors can handle the idea of going into debt to buy into ever unpredictable markets. Most of us are wired to panic and sell when the stocks we bought with borrowed money tank, thereby guaranteeing a bad outcome, leaving us in a pickle.
Still, the idea to invest with borrowed money merits some thought so let's look at how you can navigate this space!
Most of us have used leverage without knowing
Many people might look at this post title and think it only refers to using something like a personal loan to invest in a specific fund. The reality is, we use borrowed money every day as a leverage to "invest" in certain decisions in our lives. Look at the following example:
If the cost of a vehicle is R200 000 and a buyer hands over R20 000 in cash, and R180 000 in borrowed money in exchange for the vehicle, the buyer’s cash outlay was only 10% of the vehicle’s purchase price.
Using borrowed money to pay 90% of the cost enabled the buyer to obtain a significantly more expensive vehicle than what could have been purchased using only the available personal cash. Instead of driving around in an old battered R20 000 skedonk, the buyer is cruising around sunny South Africa in a shiny new car, having used leverage to acquire a better vehicle than he/she could have purchased using only available cash on hand.
The ideal concept behind leveraging
If you can borrow money for, say, 8% and then invest it and earn a return of 10% or 15%, go ahead. But, this is the dream that has caused many troubles for individuals in the past because they didn't understand the hard realities behind interest.
What we learn from history is that people don't learn from history.
It looks like a compelling plan. But, is it a good idea, or is it a whacky one? Fincheck knows one thing - your debt repayment is guaranteed, but your investment isn’t.
It’s true that leveraging can be a very powerful wealth building tool, but it can also be a wealth demolishing weapon. It could work for those who have a long investment horizon and have the risk tolerance to watch the amplified ups and downs of their account balance. The truth is, most of us don’t have the guts to pull off something like that, we’ve got stars in our eyes tailored to the upward potential, but we’d want to sell at the first sight of markets going south.
The reality is that it’s super risky business to invest with a loan. The investment you make with the borrowed funds should obviously rake in a much higher return on investment through capital gains or dividends than the interest amounting on your loan.
Don’t forget about the costs of investing such as capital gains taxes and general service fees associated with making an investment. True, the math can work in your favour, provided you factor in fees associated with investing, but the risks can be significant, stock market declines and economic weakness can mean your downfall.
The Bottom Line when choosing to invest with a loan
Experienced investors have used leverage successfully, but most would much prefer to save money to invest rather than borrow it. If someone is unable to save enough money to invest then they should address their spending and saving patterns before taking out a loan. Any investment that can increase at a rate above the cost of borrowing might be considered a win if an investor can handle the near exponential level of risk caused by leveraging.
But while you have absolutely no guarantee on the investment performance, there’s a rock hard guarantee that the debt clock will tick against you.
We’re rather fond of Warren Buffett’s clever remark: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.”
So take it from the master investor himself, the smarter thing might be to take it steady with your investment approach and leave the risky business for those with risky appetites!