Borrowing Money to Invest: Good Idea or Bad Idea?

Using borrowed money to invest is called leverage, and it’s a simple idea in theory—take out a loan to make an investment with the hope that the investment will make money in an amount which exceeds the cost of borrowing the money. Many investors may be familiar with the term “margin” which is a similar concept. In practice, however, there are many factors to consider before deciding to accept the inherent risks in leveraging, including your personal financial situation, your risk tolerance, your overall, long-term investment strategy, and market conditions. As is the case with any investment strategy, there are pros and cons.

What are some potential pros of borrowing money to invest? 

• Leverage. If your investments perform well, the returns on your investment can exceed the cost of borrowing.
• Access to Capital. Borrowing money to invest may enable you to access capital that might otherwise not be available to you. This gives you access to investment opportunities you otherwise would not be able to afford.
• Tax Deductibility. In some, although not all, cases, the interest on investment loans could be tax deductible, which can reduce the overall cost of borrowing.
• Securities Backed Lines of Credit. Some brokerage firms allow an investor to borrow a line of credit, which is subject to interest and fees, and which is secured by the investments in the investor’s brokerage account. This can be a tool to borrow money for life events, such as a wedding, home remodel, or big purchase, without the investor having to sell their investments to make the purchase.

What are the cons of borrowing money to invest?

• Increased Risk. While borrowing money to invest can magnify your returns, it can also magnify your losses. If your investments perform poorly, you must still repay the borrowed funds, which can potentially lead to major financial losses.
• Interest Costs. Borrowed money incurs interest costs, which can take a chunk out of your investment returns. Your investments must generate sufficient returns to cover the interest payments, or you can end up losing money overall even if your investment is positive, if the interest exceeds the return.
• Market Volatility. If the market experiences a downturn, the value of your investment could decline, leaving you with a loan to repay and insufficient funds to do so. Market volatility is a given, and is one of the greatest risks when it comes to leveraging.
• Margin Calls. If you invest with borrowed money through a margin account, and the value of your investment falls below a certain threshold, the brokerage firm may issue a margin call. This could force you to sell investments or deposit more funds to meet the agreed-upon margin requirements.

Other considerations 

• Your Risk Tolerance. Risk tolerance is the level of risk you, as an investor, are willing to take. You should only borrow money to invest if you have a high risk tolerance and can afford to lose the borrowed funds without significant financial consequences.
• Investment Horizon. Carefully consider your investment time horizon. Borrowing money for short-term gains can be risky, as it makes you more susceptible to the above-mentioned market volatility.
• Diversification. If you diversify your investments it can help mitigate risk when borrowing money to invest. It’s safer to spread your borrowed funds across different investments, to reduce the impact of a single investment’s poor performance.
• Interest Rates. Pay attention to the interest rates on the funds you’re considering borrowing to invest. High interest rates can make it more challenging to generate returns that exceed the cost of borrowing.

Generally, using leverage is considered an incredibly high-risk strategy which could subject the investor to severe financial losses. The use of margin and other forms of leverage is generally reserved for highly sophisticated investors and investors with enough financial assets to withstand a significant financial loss.

If your financial advisor suggests the use of margin or leverage, you should be highly skeptical. Does borrowing money to invest make sense for your investment strategy? Consider all the pros and cons, and seek a second opinion from a qualified, licensed professional. prior to agreeing to the use of margin or other types of leverage.