Historically low interest rates on personal borrowing over the past decade can allow people with good credit to capitalize on other opportunities to build their net worth, including levering to invest in real estate, businesses and even stocks.
For example, if you use a home equity loan at 4 percent to invest in an index fund with historical yields of around 10 percent, you could make a profit without putting in any savings.
Professional and institutional investors use this concept to increase their trading volumes but pitfalls abound for most individuals, especially if not careful, investing and finance experts say.
[See: 9 Things to Know About Robo Advisors.]
“Borrowed money, or leverage, can be an extremely powerful fast-track to growing your own wealth,” says Brian Davis, co-founder of the real estate blog SparkRental.com. “But it also exponentially raises the risk of investing because you’re using more money than you actually have. If an investment goes south, it can create real problems for you.”
Before rushing to borrow from your other assets to invest in new ones, consider the following tips.
Analyze the numbers. Should you invest using money from a home equity, mortgage or 401(k) loan, you would need to ensure the price appreciation of your investment plus dividends outweighed the debt service, says Evan Tarver, investments analyst for FitSmallBusiness.com.
“The single biggest issue in this analysis is the fact that borrowing costs are certain, while investment returns are uncertain,” adds S. Michael Sury, a lecturer of finance at the University of Texas at Austin. “It is this disconnect that can cause serious heartache for even the most seasoned investors.”
That said, in some instances the gap between the two numbers is so wide that it may compensate for uncertainty, Sury says. In that case, investors should carefully examine their risk and ensure they have a diversified portfolio of investments to make up for any losses.
Cut your teeth first on smaller trades. Since price appreciation isn’t guaranteed, investors should learn the fundamentals of investing in their niche before borrowing to do it, Davis says. Before the housing market crash, Davis borrowed money to buy several rental properties that resulted in negative cash flow because he didn’t understand the market.
To set yourself up for success, start small and partner with someone with more experience, Davis says. Take courses and invest only with your own money until you’ve mastered the skills.
Don’t borrow when close to retirement. The closer you are to retirement, the less risk and debt you should take on, no matter the potential gain.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
Sophisticated investors with low debt, high disposable income and who are between ages 25 and 50 are in the best position to invest with borrowed money, says Levar Haffoney, principal at Foyohne Advisors, a New York financial advisory firm.
Buy cheap. In this long-running, eight year bull market, stocks are very highly valued, says Lyn Alden, founder of Lyn Alden Investment Strategy in Atlantic City, New Jersey. That is causing some analysts to predict the market will offer minimal returns over the next decade, she says. Even Warren Buffett has stockpiled billions in cash, holding out for prices to decline.
Borrowing money to buy inflated stocks “is classic bubble behavior,” she says. So if you do borrow money to invest, it should be cheap, undervalued assets.
Consider buying on margin. Individuals with basic stock trading accounts can trade “on margin,” which means buying new stocks with the value of stocks you already own. This allows an investor to purchase more shares than there is cash available to pay for them, so gains can be pocketed when share price improves, says John Engle, president of Almington Capital, an Illinois-based investment firm. But you also pay dearly — maybe even the full value of your portfolio — for the losses when stocks trade down, too, so careful evaluation is required.
Use cheap debt to invest with your own money. Historical rates of return are not necessarily guarantees for future returns, and the market goes through bull and bear phases over time. If the tumult is too much for you, instead of using cheap debt to leverage new investments, Alden suggests taking advantage of low rates on student and auto loans and mortgages to pay them back slowly and invest the cash savings.
“For people in their 20s, 30s, 40s and 50s, it still makes sense to maintain some low-interest debts as long as they’re using that money to build assets and their overall net worth,” Alden says.
Have an exit strategy. Any investment, leveraged or not, requires a repayment strategy, says Brett Anderson, a certified financial planner with St. Croix Advisors in Hudson, Wisconsin.
Because your asset or investment can lose value over time and put you underwater, you want to make sure you have additional resources and cushion to support the liability or debt service you used to purchase it.
And if you don’t, it’s time to hold off.
[See: 10 ETFs to Buy for Oodles of Growth.]
“It’s better to save and work your way up to the big leagues rather than borrow your way into the game,” Tarver says. “If you see an investment with a 10 percent return potential, it shouldn’t matter if you invest $1,000 or $100,000.”
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Borrowing to Invest Is Risky Business originally appeared on usnews.com
