Global stock markets have largely been on an upward march in recent years (March’s sell-off aside) and that may have increased the temptation to borrow money to put into the stock market.
The idea behind this strategy is that you aim to invest your money so it grows at a greater rate than the interest you pay on the loan you have taken out. And while mathematically that sounds like a good idea, it is not without risk. Here are a few things to consider first:
Will I get enough to repay the loan?
Making more money to pay back the loan is not as easy as it might seem. Christine Benz, director of personal finance at Morningstar, warns that investors should carefully think about they can realistically earn on different types of investments. “In this case, there is a mismatch between a guaranteed obligation (borrowing cost) and the return, which is uncertain regardless of where you invest unless you’re in cash,” she says. “And with cash vehicles you won’t come close to matching your borrowing costs.”
Interest rates are lower than they have ever been. But even if the rate of interest on borrowing is lower than in the past, it is still a hurdle for an investor to beat if they want to generate returns over and above their interest payments.
This means that investing in safer asset classes like bonds is a no go – not only do you have the potential to lose money, but you might also not make enough to offset the loan. “The average return falls with bonds, so it might be uneconomical to do it. It really depends what rate you can get,” says Benz.
Another factor to consider with investing is costs: platform fees, fund ongoing charges and stock trading costs all eat into returns. We have previously looked at how to keep investment costs down, but regardless, it still costs money to invest and that needs to be factored into your calculations.
What if I sell at the wrong time?
Stock markets tend to be more lucrative than the bond market, but with higher potential returns come greater risk and volatility. As we saw in March 2020, the stock market can sell off quickly and sharply, often with little or no warning.
A further complication is that market valuations are high today after a strong recovery, which further enhances the risk of borrowing to invest, says Benz. If your investments suffer a fall that’s problematic because repayments on a loan won’t wait – while you might have the risk tolerance to wait for a stock market bounce back, you’ll have to be sure you can meet your financial obligations in the meantime.
“That means you might be forced to sell an investment at the wrong time,” says Benz. “It’s psychologically very hard to sell your investment if you have lost money, but you might need that money to make the repayment.”
Are you comfortable with the situation?
Maths aside, investing is risky. Being comfortable or not with having debt is purely a personal matter, but there is always the chance you could lose money which you need to on hand to pay back that debt. “Debt is guaranteed, and you are balancing that by putting the money in something that is not guaranteed,” says Benz.
And while it’s obvious in hindsight that this strategy would have worked perfectly had you taken out a cheap loan and put the money into Amazon shares a decade ago, it’s almost impossible to predict and the chance of finding the next ten-bagger is fairly small. Benz suggests thinking about thing differently: “If you know you have the money each month that you’d use to make a loan repayment, why not set up a regular investment plan and invest it each month instead?”
She adds: “Borrowing money to invest might be something that some sophisticated traders may engage in, but generally speaking for more small investors managing their account it adds risk, complexity and costs - something I would advise against.”
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