Borrowing to Invest
Borrowing to invest is very risky. This practice which is also called leverage or gearing is a practice that only experienced investors should try. It is a medium or long term strategy which can be done through investment property loans or margin loans, and the investment serves as collateral for the loan. When it works, you get high returns, but when it doesn’t, and the market falls, you end up with multiple loses because your investment value decreases and you still have loan obligations to meet. The loans for this investment can be acquired through two means:
Margin Loan: This allows you to borrow money which you invest managed funds, exchange-traded funds, and shares. Margin lenders require that you keep the ratio of the value of the loan to the investment (Loan to value ratio) at a certain level which is usually 70%. The LVR will go up if the value of your investment drops or the loan gets bigger. Where the LVR passes the stipulated level, you are expected to reduce it to the level agreed upon within 24 hours.
There are several ways to reduce the LVR, and they include:
- Depositing money so that your margin loan balance will reduce
- Adding more managed funds or shares so your portfolio value will increase
- Selling part of your portfolio and using it to cover part of the loan balance.
Where you are unable to reduce the LVR, the margin lender will sell a part of your investment, thus reducing the LVR.
When you consider all these, you will understand how much of a risk margin are. There is a likelihood of losing more than what you invested.
Investment property loans: They are loans that you can use for investing in real estate assets such as lands, commercial and residential buildings, etc. Income will come through rents, but these may not be enough to cover your loan obligations and the cost of owning the property. Even when the property is empty, you still have to pay those costs. Thus, it is high-risk too.
The Risk of Borrowing to Invest
Borrowing to invest is not without advantages. It gives you the opportunity to invest any time, you can acquire bigger investments and increase your investment earnings, and it may come with tax benefits. However, the risks are high and self-evident. The major risks are:
- Capital Risk: You may be forced to sell your investment at an unfavourable price when your investment value drops, which means the price you sell may be less than the loan balance.
- Bigger Losses: the more you borrow, the more you lose when investment value drops, and loan obligations remain
- Investment Income Risk: there is a likelihood that investment earning is lesser than your expectations
- Interest Rate Risk: if the loan has a variable rate, the interest rate and payment may rise.
Thus, you should never borrow to invest except if the return after tax on the investment is higher than the combined cost of the loan and investment.
How to manage the risk in an investment loan?
- Look for the best investment loan.
- Never borrow the highest loan amount.
- Set money aside for emergency
- Pay interest on time.
- Diversify your investment
- Don’t use your home as collateral.