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With interest rates so low you might be very tempted to borrow money inexpensively and invest that cash for a higher return. When I say “invest” I’m not really including the idea of borrowing money to buy a home. I’m talking about borrowing money for investment purposes only.
In some cases, this can really be a shrewd move but in other situations it can lead you to a world of pain. How do you determine if it makes sense to take on debt to invest or not?
On the face of it, you might think that this is a simple math question; how much will it cost you to borrow the money vs how much will you earn? While these two questions are indeed central to the decision, there are at least 4 other questions you must ask:
Table of Contents
Are Your Costs Fixed?
This is a pretty easy question to answer. When you borrow money the agreement typically spells out the rate being charges and whether or not it is fixed or variable. Just make sure you understand this and all the terms. When is the loan due? Is there a pre-payment penalty? Can the rate adjust up or down? Based on what? How often?
In order to really understand what you are getting into, it’s important to be clear on all these issues.
How Certain Are Your Returns?
If you are investing in mutual funds or stocks don’t kid yourself. There is no way to know what the returns are going to be. You might have be considering a fund or stock with a wonderful track record or story – but there is no way to know what that investment is going to return.
Even if you are borrowing money at a low rate to lend to someone else at a higher rate, how sure are you of those higher rates? What happens if the other party fails to make payments? What collateral do you have? This is one reason why peer-to-peer investing scares me. The rates look juicy but what happens if the borrower goes belly up?
Make sure you really understand the returns and how certain or uncertain they may be.
How Will This Impact Your Cash Flow?
If you borrow money to invest you’ll probably have to make a monthly payment. But if the investment you are about to make with those borrowed funds doesn’t provide a monthly income, how are you going to make your payments?
No matter how attractive an investment might be, if you can’t handle the cash flow, I suggest you pass. Even if the cash flow looks good, consider a “worst case” situation. What happens if the investment you make doesn’t work out? How would that impact your cash flow and overall financial situation? Always have a plan “B” before you need it.
Are You Experienced?
Besides this being the title of an unbelievable Jimi Hendrix album, it’s also a good question for investors. And if you are going into hock in order to make an investment it’s an even more important question to ask.
You don’t know you don’t know something until you know it – and by the time that happens, you might be in trouble. Investing rarely goes exactly as planned. There are always variables and unknowns. If this is your first time around with this type of investment you need to be extra cautious. I strongly suggest that you refrain from borrowing to invest if you have little to no experience in the specific kind of investing you are contemplating.
Borrowing to invest can work out great because it uses other people’s money to make money for yourself. This in general is a great financial tool. But it comes with a price; risk. The more experience you have, the more sure you are of the costs and returns and the less impact a bad outcome has on your cash flow, the more this move can make sense.
But if you have doubts about any of these variables, it might be better to keep your powder dry. Wait a little longer. Save up and make smaller sized investments. This way you learn and gather experience without it being too costly in case things don’t go as planned.
[Photo Credit: Steve Johnson]
I have over 15 years experience in the financial services industry and 20 years investing in the stock market. I have both my undergrad and graduate degrees in Finance, and am FINRA Series 65 licensed and have a Certificate in Financial Planning.
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