Would Borrowing Money To Invest Get You Into Trouble?

Investors would, in the course of investing, periodically face the issue of not having sufficient cash. This could be due to a few reasons – the investor could be “fully vested” (meaning he has no spare cash for further investments and has to sell a position in order to buy another), he may have a major expense coming up (e.g. house renovation, buying a car, birth of a child) for which he has to set aside a sum of money, or he may have faced a medical or personal emergency which has drained a substantial portion of his cash. In such a situation, it seems tempting to borrow money so that he can invest, given that attractive opportunities are appearing with markets tanking. In this article, I explore the pros and cons of borrowing to invest.

Options galore

There are several ways the investor can take up a loan for investments. Various banks offer “balance transfers” on credit cards, which are a form of cheap short-term loans which can be used as a way to obtain cash. An equity loan can also be taken up in the form of margin financing, where the investor’s shares are pledged as collateral (i.e. security) for a loan. A third method would be “Contracts For Difference” (“CFD”) which is a form of margin trading whereby a brokerage firm lends money for buying or short-selling shares or derivatives.

With myriad methods available out there for borrowing money, the investor is thus spoilt for choice. It would seem that credit is easily available and that there are many avenues for obtaining funds to plough into the stock market to take advantage of falling share prices.

There’s no free lunch

However, investors should take note of the risks associated with such loans.

The first is, of course, repayment risk. No one takes out a loan expecting not to be able to pay it back, but due to the unpredictability of life, an event may occur which causes a substantial drain in the investor’s money, and he may then find himself having much less cash than he once did. If we add in the loan to be repaid, this acts as a double-whammy for the investor.

Then there is also the risk of falling share prices triggering a margin call, which refers to the “topping up” of the collateral for the loan to continue on. As an example, suppose an investor borrows S$8,000 on the market value of his shares worth S$10,000. This would represent 80% loan-to-value (“LTV”) and if this LTV rises to higher than 85% for example, the loan may be immediately recallable. Hence, if the value of the shares drops to say, S$8,000 (-20% drop) due to a market downturn, then the LTV would increase to 100% and the investor would be required to inject funds to ensure the LTV stays below 85%. This can have a harmful effect on the investor’s cash flow and the margin call is usually triggered when the investor can least afford it.

The Foolish takeaway

Borrowing to invest is thus a double-edged sword – if things go well, you can make lots of money; but if events turn bad, there is a good chance of losing your pants. Therefore, borrowing to invest is something I would strongly discourage.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.