Borrowing to Invest
Borrowing to invest, also referred to as leveraging or gearing, inherently carries significant risk. It’s a strategy that typically suits seasoned investors and should be considered primarily for medium to long-term investments. The borrowed funds can be obtained through investment property loans or margin loans, with the investment itself often serving as collateral for the loan. In favourable market conditions, leveraging can lead to high returns. Conversely, in a market downturn, the outcome can be considerably damaging, with a decrease in investment value coupled with the ongoing obligation to meet loan repayments.
Margin Loan: This type of loan enables you to borrow money to invest in managed funds, exchange-traded funds (ETFs), and shares. Lenders stipulate a certain loan-to-value ratio (LVR), commonly around 70%, which needs to be maintained. The LVR will increase if your investment value declines or if the loan balance grows. Should the LVR exceed the agreed-upon level, you’re required to restore it to the acceptable level, typically within a 24-hour period.
There are several strategies to reduce the LVR:
1. Deposit additional funds to lower your margin loan balance.
2. Expand your portfolio with more managed funds or shares to increase its overall value.
3. Sell a portion of your portfolio and apply the proceeds towards reducing the loan balance.
If the LVR remains high and you’re unable to reduce it, the margin lender may sell a portion of your investment to decrease the LVR. When you consider these factors, the inherent risks of margin loans become apparent, with the potential for losses exceeding your initial investment.
Investment Property Loans: These loans are designed for real estate investments, including land, commercial buildings, and residential properties. Rental income can offset some costs, but it may not be sufficient to cover loan repayments and the associated costs of property ownership. Additionally, vacant periods when the property isn’t generating rental income still necessitate loan and property expenses repayments, underscoring the high-risk nature of this investment strategy.
The Risk of Borrowing to Invest
Borrowing to invest, while it comes with certain advantages, isn’t without its significant risks. This strategy allows for immediate investment, provides the potential for more substantial investment holdings, augments the possibility for greater investment returns, and might even offer tax benefits. However, the inherent risks are considerable and cannot be overlooked. Here are some of the primary risks associated:
Capital Risk: Should the value of your investment depreciate, you may be compelled to sell your investment at an unfavorable price. The selling price could potentially be lower than the remaining loan balance, leading to a financial deficit.
Amplified Losses: The more substantial the borrowed amount, the greater the potential loss when the investment value plummets. Keep in mind that regardless of how your investment performs, you’re still obligated to fulfil your loan repayments.
Investment Income Risk: There’s a risk that the earnings from your investment might fall short of your initial expectations, which can negatively impact your ability to repay the loan.
Interest Rate Risk: If your loan comes with a variable interest rate, there might be unexpected increases in the interest rate and consequently, the payment amount.
As such, it’s essential to carefully consider your decision to borrow for investment purposes. Only borrow to invest if the post-tax return on the investment is anticipated to exceed the total cost of the loan and the associated investment expenses. It’s always wise to consult with a financial advisor or expert before making such decisions to ensure you fully understand the implications and potential outcomes.
Managing the risks inherent in an investment loan demands careful planning and strategic execution. Here are some essential steps to consider:
1. Seek the Best Investment Loan: Like any financial product, not all investment loans are created equal. It’s crucial to shop around and compare different lenders and their terms to ensure you secure the most suitable loan for your investment needs and financial circumstances.
2. Avoid Maxing Out Your Borrowing Capacity: While it might be tempting to borrow the maximum amount offered, this strategy can backfire if market conditions fluctuate. To mitigate risk, borrow only what you need and are confident of repaying, even if market conditions change.
3. Establish an Emergency Fund: It’s always wise to have a safety net in the form of an emergency fund. This money set aside can cover unforeseen expenses or cushion the impact if your investment doesn’t perform as expected.
4. Timely Interest Payments: Ensure you’re capable of making the interest payments on your loan on time. Late payments can lead to additional charges and negatively impact your credit score.
5. Diversify Your Investments: Don’t put all your eggs in one basket. A diversified portfolio spreads your risk across various types of investments, which can help protect you if one of them underperforms.
6. Exercise Caution with Collateral: Using your home as collateral for an investment loan introduces an additional level of risk. If your investment fails, you could lose your home. Always consider this risk carefully before opting to use your home as security for an investment loan.
Remember, prudent risk management is essential to successful investing, especially when borrowing to invest.