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Borrowing to invest is expensive

This is part of a series on why borrowing to invest isn’t really a great idea.

The first article in this series saw me admitting that even though I hate debt, it isn’t hard to see the apparent attraction of:

  1. Borrowing a suitcase stuffed with money
  2. Sticking it in the stock market for 20 years for the historical average annual rate of return of 10%, then…
  3. Spending the rest of your life telling people around a pool in the Virgin Islands how clever you were 20 years ago.

The rest of these articles are going to pop that balloon.

Firstly, let’s start with the cost of your debt.

Whatever amount of money you manage to borrow, before you put 10% a year into a compound interest calculator and dream of living off the winnings, realise you won’t see the full market return on your investment, even if your investment does go up nicely.

That’s be cause your loan is hardly going to be free!

You will need to pay interest on the loan, most likely as regular monthly or annual payments, or possibly as a one-off when you cash out in 20 years time.

And debt is expensive.

If you have to take out af personal loan, it’s likely the interest repayments will near cancel out your gains right away, since rates are seldom much under 10% these days. (I’m ignoring tax for now — it only makes it worse).

It’s likely the only way the sums will make sense at all is if your debt is secured against your house so you’re raising money via a mortgage.

But even taking a loan at a very cheap long-term mortgage rate of 6% will more than halve your expected returns.

Look for the hidden cost of the debt

Sometimes people get confused, because financial companies offer them ‘geared’ investments that magnify the gain using debt, or they open a spreadbetting account and discover they can take big bets equivalent to say £10,000 with just a £1,000 deposit.

They think — wrongly — the debt is free.

In fact in both cases you’re still paying to borrow money:

  • In the first case, the interest charge will be docked from your returns.
  • With spreadbetting, the cost of the loan will be included in the spread.

If you can’t see where you’re paying the market rate for your loan — or more —  then you’re not looking hard enough.

In short, nobody is going to give you free money. The resultant cost of debt devours your returns and often makes borrowing to invest unworkable — especially if you’re unable to shelter your returns from tax, as we’ll see later.

I understand some people will argue they intend to make 15% or 20% or 25% a year from their investment of borrowed money.

Given that the great investor Warren Buffet’s returns are less than 25% a year and very few professional fund managers are able to beat tracker funds year-on-year, I don’t really have anything to add except to wish you all the luck you’ll need.

Fact is if you can achieve 20% consistently on your investments for years on end, you shouldn’t be borrowing to find the money — you should get yourself a six-to-seven figure salary working as a highly-paid fund manager!

Series NavigationWhy borrowing to invest is a bad ideaTax and costs will eat up returns

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{ 3 comments… add one }
  • 1 Neal@wealthpilgrim.com September 4, 2009, 7:40 pm

    So important…yet when someone is convinced that borrowing to invest is the thing to do, all the logic in the world usually doesn’t deter them.

    Debt is a certain cost. Returns are projected. That equals risk. We can’t ignore that risk…or when we do, we get into trouble.

    Thanks,

  • 2 James January 5, 2010, 4:10 pm

    I strongly only borrowing to invest if you have already decided your investment and you are only looking to borrow if the possible returns greatly outweigh the initial investment.

  • 3 George April 11, 2010, 5:49 pm

    If you have a mortgage and you are also investing, then you are borrowing to invest. Thus it is in your best interest to ensure your investment returns significantly outperform the mortgage costs.

    Realizing this, one could (in the USA) currently refinance using a 10/1 ARM to get the best rate, often in the 3.85% range and then invest in bond funds returning 6.5% or higher.

    For myself, I know that means I’ll be able to pay off the house in 5 years instead of 7 years with the previous 4.85% 15-yr fixed mortgage and savings rate.

    My risk has decreased because of the available cashflow (30% reduction in mortgage payment + cash out = available investment reserve went from 3 months of expenses to 18 months of expenses).

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