BORROWING TO INVEST
Borrowing money to invest is often referred to as “leveraging” and is a risky investment strategy. When you invest your own money your potential loss is limited to the amount of money that you invest. However, when you borrow to invest you can lose more money than you have personally invested, and can end up in debt. This is why leveraging is risky, because it can magnify investment losses. The risks are higher for senior investors who may have less time to recover from a loss, and who may be more likely to require money from their investments unexpectedly.
Let’s look at a simple example involving Investor A who has invested her own money and Investor B who has invested some of her own money and borrowed a further amount of money to invest:
Investor A: Invested Own Money
Investor B: Borrowing to Invest
|Own Money Invested||$1000||$1000|
|Borrowed Money Invested||$0||$4000|
|Total Money Invested||$1000||$5000|
|Percentage Decline in Investment||30%||30%|
|Value of Investment After Decline||$700||$3500|
|Investor’s Own Money Remaining||$700||– $500|
As we can see in the example above not only has Investor B lost all of her original $1000 investment, she also now owes $500 more than she has in her account. If her leveraged investments continue to decline she may end up owing even more than $500, and depending on her overall financial circumstances this can have a significant impact on her financial future.
Compare the situation of Investor B to Investor A. Both investors invested the same amount of their own money and experienced the same 30% investment loss. Yet, Investor B has lost her own money of $1000 and owes $500, while Investor A has only lost $300, still has $700 in her account, and owes no debt.
There are further risks when employing a leveraging strategy including:
- You can lose any collateral used to secure the loan, such as your home.
- Even with low interest mortgage rates that are available today investing borrowed money from a home equity line of credit is a risky strategy. Because such loans are secured by the equity in your home you risk losing your house if the investment strategy fails. This is a serious risk that should be considered before ever using borrowed funds secured by the equity in your home to invest.
- The value of any distributions from the investments could fluctuate downwards and may not always provide enough money to cover monthly loan payments.
Be cautious of any one who tells you any of the following statements regarding a leveraging strategy:
- It’s what rich people do
- The strategy is guaranteed to succeed
- The strategy will pay for itself
- It’s a “No Brainer”
- All my clients are doing it