Many of us are raised with a straightforward outlook on how to manage money: borrowed money is bad, investments are good. Perhaps that’s why the idea of borrowing money to invest in stocks seems so outlandish. However, it’s a strategy that many industry moguls and savvy investors use to maximize their returns over time.
Here’s what you need to know about buying stocks with borrowed money and whether it’s the right option for you.
Why borrowing money to invest should be easier than you think
Understand the risk to understand the opportunity
Tips to follow when borrowing money
Carrying debt has been vilified in our society, and for a good reason. According to the Federal Reserve Bank, Americans owe $1 trillion in credit card debt, with nearly half of those individuals carrying a balance from month to month.
Additionally, many in the Millennial generation are carrying significant student loan debt incurred on the precipe of the great recession in a time when a degree does not hold as much weight as it used to.
With those considerations in mind, it is no surprise that borrowing to invest might sound insane. However, using borrowed money to purchase stocks can set investors up for long-term success when done correctly.
Look beyond credit card debt and consider what assets people borrow money to attain: houses, cars, etc. We consider this significant incurrence of debt as a positive, as these investments help facilitate our daily lives. Mortgages, in particular, become a nest egg of equity over time, sheltering us while investing in the future.
So the concept of borrowing to invest should not be abstract— we just do not have a tangible representation of that investment. Similarly, if you have a mortgage or a line of credit and start investing before paying down the debt (which is recommended), you are effectively using borrowed money to invest.
In essence, you could use the money you are putting into your investments to pay down your line of credit faster, but you are choosing not to because it makes better financial sense.
Borrowing to invest comes down to leverage and margins. Companies often use leverage as an investment strategy, increasing debt for a calculated return on investment that increases shareholder value.
A margin loan is an act of borrowing against your existing assets to free up money for additional investments. For example, if you have $5000 worth of marginable securities, you could borrow up to $2500 (depending on the terms) to reinvest in other stocks.
The downside risk of this approach is that you could experience a margin call if the value of your investments drops beyond the allowable threshold. At this point you would be obligated to pay the balance of what you borrowed.
Many investors decide to draw from the equity in their home with a home equity loan to invest in stocks and bonds. This is a smart choice for investors with over 20% in home equity. A home equity loan tends to have lower interest rates and is secured by the property as collateral.
While this tends to be a low-risk approach to borrowing for investment purposes, ensuring you can meet the loan terms is essential so you do not forfeit your property.
So why does it benefit investors to borrow money to purchase stocks?
Beyond creating an opportunity to invest, this strategy buys the world’s most valuable asset of all: time. Every investor knows that the earlier you start, the better. This is due to a bit of magic known as compound interest. Yet, many of us lack the resources to start investing during our 20s. Strategically borrowing to invest can help get an earlier start on building a stock portfolio.
For those of us trying to build a credit history or improve our credit score, strategic borrowing can also be helpful. Those who go bankrupt start rebuilding their credit by taking small loans and paying them back. While you can go through the motions of a credit repair process, having someone remove the item from your credit report, incurring a small amount of strategic debt to invest can offer benefits on both sides of the equation.
Investing in stocks also offers tax advantages, which helps offset the costs of borrowing to invest. Depending on how you borrow— a home equity line of credit, for example— interest payments may also be tax-deductible.
Borrowing to invest is meant for people with investing experience who have a high tolerance for risk. Borrowing money to purchase stocks can maximize your investing power. It can also add more complexity and risk. Talk to your financial advisor before exploring this avenue.
Hearing the success stories about people who buy stocks with borrowed money leads many aspiring investors to use this strategy. However, the following individuals should not borrow to invest:
Again, first-time investors should avoid this strategy, and all investors should discuss their options with their portfolio manager or a financial advisor.
Borrowing to invest in stocks is a potentially profitable opportunity for those with an established portfolio who are willing to incur some risk to diversify and maximize their investments. In addition to discussing this strategy with a financial expert, you should also:
Borrowing money to purchase stocks isn’t without risk, but these steps can help you minimize the impact of that risk.
Taking a loan can be a powerful way to maximize your investment returns and build wealth. Take the time to crunch numbers and plan for the worst-case scenarios when exploring this potentially profitable investment option.