Money Borrowing is often considered to be a bad habit! But still we have home loans, personal loans, Car loans so do you think it’s a good idea to borrow money for investment as well? Lets dive in to find out –
Is it wise to borrow money and invest?
Borrowing to invest is known as leveraging or gearing. And some recommend their clients to leverage for investing, few others have a contradicting viewpoint. Gearing has a positive impact when markets are on the rise, however they could dig a deep hole in your pocket when the markets fall.
Pros Of Borrowing To Invest
For a person who comes under a higher tax bracket, could get tax deduction for his interest payments.
Just for example you have a home loan and you are paying the EMI’s, then the EMI that consitutues of Principal and interest could be claimed under two separate sections of the Income-tax Act, 1961. Principal repayment can be claimed as deduction under section 80C of the Act, whereas interest under section 24(b).deduction under section 80C, which has an upper limit of Rs.1.5 lakh. However, section 24(b) provides exclusive deduction against interest payment on home loan
Please note that the above scenario would only make sense when the returns on investment [after tax] are greater than the cost of the debt.
Risks Associated with Gearing
Make sure to get answer to these questions –
What’s the duration provided by the lender to repay the amount, that would help you to decide on the instruments to be picked up.
The interest paid on the loan amount? Is providing you with a greater return?
What if your investments didn’t grow as expected? How would you repay the loan?
Investments are market linked,but loan amount is fixed
Are there any tax implications of borrowing and investing?
If you are putting your money to buy a house, would you be in a psotion to sell it off instantly in case a situation arise?
Primarily you could categorize these into different kind of risks like –
Investment income risk
In case when the income an individual receives from the investment is lower than the expected, your corpus/plan B to cover it. For example – Jane Smith invests in the ABC Money Market Fund, which has a maturity of less than one year. If interest rates are up at 6%, then the money market yield increases and the fund has a payout of 5.75%. If interest rates drop to 3%, the fund’s payout could also drop to a rate of 2.75% because when money markets mature, their returns are reinvested at much lower interest rates.
In such cases you need to have a corpus or plan B to pay out debt.
Interest rate risk
With volatility in the market, the interest rates are not constant anymore. So if there is a hike in interest rates, would you be able to make repayments?
Your income that you may be using to repay your monthly installments, if that does not exist. How do you plan to repay the amount?
What if market falls, and that may affect your investment returns, and also the sale of liquid assets goes down. How would you pay the loan amount in that case?
Illustration – Net Returns from investing with borrowed money vs. investing your own money
Lets pick an example to see what are the net returns with borrowed money vs. investing your own money.
Mar’14 – Mar’15
Mar’12 – Mar’13
Mar’14 – Mar’15
Investing with Own Money
Investing with Borrowed Money
Investing With Borrowed Money
Return On Portfolio
Gains On Portfolio
Interest Cost @ 12 % p.a
Assumptions – Money is invested between March 2014 to March 2015,Rate of interest is assumed as that on Personal Loan.
It can be seen from the above illustration that while decent gains can be made by investing money in stock markets, if the same is done with borrowed money, the returns are considerably low. In the time period when market returns are modest, any gains made are completely erased by interest cost if investments are made from borrowed money. One actually loses money instead of making it.
Even when the portfolio returns 8% still you are in the negative, imagine what would happen in a falling market.
Factors that can affect the returns by investing with borrowed money
Some of factors that could affect your returns when investment made via borrowed money are –
Choice of Investments
Can I generate returns above interest rate if I invest from borrowed money?
As an example, let’s imagine you purchase an investment property for 400,000 located in a location where vacancy rates are low and demand for rental properties in the area is very high.
You rent the property to tenants for a strong rental return of 500 per week. The repayment costs for your property (loan repayments/property management fees/rates etc.) totals 410 per week. Therefore, after all expenses this property is increasing your income by 90 per week and in turn is paying for itself. In this situation the property is positively geared!
One of the important aspect of borrowing is not all types of borrowing are bad! There are some good debts and some bad ones. Just for example – Home Loan, Education loan, or Business Loan fall under good debts because “you need money to build something good”. So when it comes for home loan – you are building a house, saving on tax and real estate prices mostly appreciate, so an asset for yourself. In a similar manner Education loan where you are gathering knowledge and progressing high in your career, and even business ideas to nurture, create employment and more money business loan are good.
On the other hand Car loan, Home Improvement Loans are considered to be bad debts.
Points to keep in mind while borrowing to invest:
Make sure to –
Take a conservative path while using debt for investment purposes.
Make more down payments, that would in turn reduce your liability to some extend
Make a wise decision while choosing the investment options
It is not advisable to buy a vehicle with a loan, as a vehicle is termed as a depreciating asset
Even buying a house through borrowed money is not recommended, as you may not be able to dispose off and get money as you would be living in it.
Is it safe to use over-draft facility to invest money?
Overdraft facility is a service provided by banks to the individual against his assets/collaterals with banks. However, every bank has their own interest rates and terms while sanctioning overdraft facilities.
Experts strictly recommend not to use Overdraft facility to invest in stock markets or other investment decisions considering the fluctuations in the market. With result to volatility Individuals may lose the asset/collaterals also.
Opt for overdraft facility if you require finance for short term in emergency situation. Pay the interest regularly on your overdraft and repay the overdraft amount on time to the bank. In case you fail to repay the amount, the bank will liquidate the asset against which you took an overdraft.
We hope we have answered your queries on whether one should borrow money to invest or not?If you still have any unanswered questions or need help, feel free to contact us here.
We would be glad to help you with your planning and investment related decisions.