Should You Borrow Money To Invest?
Did you know that you can borrow money to invest? This blog has everything you need to find out about investing by borrowing.
Source: Freepik
Investments. Schemes, Proposals, and Money.
People love to save and invest money in different avenues that promise them healthy returns. The lure of earning passive income attracts everyone to the various investment schemes that generate varying returns.
But what about human greed?
Not everybody is earning those high salaries or running vast businesses. Then, how will such people maximize their returns?
– By borrowing and investing it!! Well, let us explore it in this blog below.
What Exactly is Borrowing Money for Making Investments?
Investing borrowed money is also referred to as “investing in a loan.” It refers to a situation where a person lacks an investible surplus (the spare cash you can invest) and borrows money to invest in the different schemes.
What is Borrowing Money?
Borrowing money refers to taking loans from different lenders, such as banks, financial institutions, private moneylenders, etc.
This loan is usually backed by assets and granted based on collateral security, which is higher in value than the amount of loan granted. In cases of default, usually, the lenders seize or take control of this collateral security and cash it for the recovery of the loan amount.
How Do You Invest a Loan?
The money you borrowed from the different lenders invested into the various avenues of investments, such as
- Stock Market
- Annuity schemes
- Debt instruments, such as Bonds and Debentures
- Canada Savings Bond
- Exchange-Traded Funds
- Mutual Funds
- Guaranteed Investment Certificates
- Real Estate
- Treasury Bills, etc.
One size does not fit all, and hence there is no single strategy that applies to all the above investments. You can certainly generate returns by investing the borrowed money, provided you follow the correct procedures and the rule of thumb.
What Is the General Mantra or The Rule of Thumb for Investing Loans?
Every loan you have secured from an unregulated money lender, or an established financial institution has a fixed interest rate (also known as coupon rate). You will be required to pay interest over that loan at specified periodic intervals, usually at monthly breaks.
However, sometimes, you can also get a loan cumulatively, wherein you will be required to pay a cumulative interest to your lender at the end of the loan tenure.
When you invest your loan into any investment option, you will generate a return from it. This return will vary with the type of investment made, where you will receive monthly/quarterly interest and, in some, you will get a cumulative amount upon maturity.
As per the rule of thumb, you must consider investing in a loan if,
| The rate of return at which you will get paid from your investment Is more than The rate of interest charged by your lender |
Or,
| The cumulative return from your investment (that you will receive upon maturity) Is more than the The cumulative amount of loan (that you will be required to pay at the end of loan tenure) |
Let us understand this rule through an example.
Mr. A is a salaried professional and is working with a Canadian IT company as a Software Developer. His salary is $70,000 per annum but being the sole earner in a family of six, he can hardly save any money. Getting inspired by one of his colleagues, he invested borrowed money into different investment options.
He is getting a personal loan from a financial institution at an interest rate of 12.5% per annum and has shortlisted the following investment options:
| Scheme | Investment Options | Offered Rate of Return |
| A | Debentures of ABC Manufacturing Inc. | 15% |
| B | Mutual Funds (with monthly dividend payout option) | 10% |
| C | T-Bills | 6% |
Advice to Alex
Following the general rule of thumb, Mr. A should invest his borrowed money only in Scheme A, Debentures of ABC Manufacturing Inc. This is because the rate of return generated from this scheme (15%) is higher than the rate of interest charged (12.5%).
It amounts to arbitrage, and Alex could gain a healthy spread of 2.5% (15% – 12.5%) if he invests in this scheme.
What Are the Unique Challenges with Investing in a Loan?
While investing in a loan might seem easy and a safer option to many investors, they must overcome a few challenges. Some of the primary challenges that investors face while investing in loans are:
- Cashflow Mismatch: It is possible that you might be required to pay interest on your loan monthly while receiving returns from your investments at a different time, say quarterly. It will create a cash flow mismatch and lead to a cash crunch.
- Fluctuations in Returns: Some investment schemes offer a fluctuating return that varies and keeps on changing. If any such variation causes the rate of return to go below your interest rate, this will lead to negative returns and a loss.
- Prompts Risky Investments: to cover your interest rate and earn a higher spread, it might tempt you to search for lucrative investment opportunities that pose a higher capital risk. It can affect the overall asset quality of your portfolio and can lead to capital losses.
Conclusion:
Investment of borrowed money is a tricky process and requires a lot of due diligence from the investor’s end. This process will generate profits only when an investor can establish a positive spread (the difference between the rate of return from investment schemes and the Interest rate paid on a loan).
Hence, scrutinize the different investments and loan opportunities available and invest if you can maintain your expected spread until maturity.
