Should You Borrow Money to Invest? 9 Financing Principles You Should Know

Should You Borrow Money to Invest? 9 Financing Principles You Should Know

It’s common to see people asking: Can I borrow money to invest and make some sweet arbitrage profits if my loan interest rate is 2% and the stock market gives me an average annual return of 5%? 

Well, let me spill the beans and cut to the chase – it might not be a great idea for the average Joe.

Don’t get me wrong, borrowing for investment isn’t entirely out of the question, but it’s like walking a tightrope with strict conditions and limitations. But most folks jump headfirst without properly evaluating the risks, and guess what? They end up doing more financial harm than good. And that’s not what they expected at the beginning. However, if you’re dead set on borrowing for that sweet investment, whether in stocks or any other money-making shenanigans, you better understand the potential risks you need to take before diving in. As the Chinese military strategist Sun Tzu once said, “Know the enemy and know yourself; in a hundred battles, you will never be in peril.”

In the following blog post, MoneySmart will review the risks of borrowing for investment so you can be assured to make an informed decision when it comes to borrowing.

What are the risks of using a loan for investment?

Before we take out a loan for investment, here are the heads-up you should note down.

Risk of cash flow disruption

Having sufficient cash flow to repay the loan is one of the most important factors to consider before borrowing.

Sure, you may have a steady job and think you’re all set, but here’s the deal: cash flow stability goes beyond just your current situation. Life can throw curveballs at you – think unemployment, health issues, or unexpected family emergencies. These can disrupt your income and leave you high and dry when it comes to repaying that loan.

While the loan amount may seem small when considering only the interest, most repayments include both the principal and interest, resulting in a significant cash outflow after repaying a portion of the principal.

And let’s take a step further, considering the potential of an economic downturn and a stock market crash. Imagine losing your job during tough times while your hard-earned money is stuck in the stock market, but you still have to deal with the pressure of loan repayment every month. There is a risk of cash flow disruption.

In the worst-case scenario, you may be forced to sell assets that you should not have sold and suffer losses beyond your current capacity.

So, when it comes to borrowing for investment, it’s best to steer clear of these risky situations from the get-go. It’s always wise to take a step back, evaluate the risks, and consider whether you really want to take a risk like that.

Risk of rising interest rates

Regardless of whether you borrow a mortgage or a personal loan, interest rates are variable.

Just because the current loan interest rate is 2% does not mean it will stay at 2% for the next few years. If interest rates rise, the gap between the loan interest rate and the expected investment return will narrow.

For example, let’s take a loan amount of HK$1 million over a term of 5 years.

If the interest rate is 2%, the total interest paid over 5 years would be HK$51,665, with a monthly repayment of HK$17,528.

However, if the interest rate increases to 5%, the total interest paid over 5 years would be HK$132,274, a difference of HK$80,609. The monthly repayment would be HK$18,871, which is HK$1,343 higher than when the interest rate was 2%.

Total Loan Amount Tenure Interest Rate Monthly Repayment Total Interest Expenses
HK$1,000,000 60 months 2% HK$17,528 HK$51,665
HK$1,000,000 60 months 5% HK$18,871 HK$132,274

Of course, such drastic changes in interest rates are not far from us, as we have already witnessed interest rates rising from 0.25% to 5.25% in the past 18 months.

In short, interest rates definitely must be taken into consideration when it comes to borrowing a loan.

Risk of investment failure

Investing does not guarantee profits, let alone when borrowing to invest in higher-yield products. The financial leverage from borrowing can magnify losses if the investment itself does not perform as expected. So, focusing on long-term investments can increase certainty.

But don’t forget that most loans do not provide a super long repayment terms (most of them have the longest tenure of 60 months) and as time goes on, the accumulated interest costs continue to increase. That’s the risk to be put under consideration.

Risk of insufficient mental fortitude

While the stock market can have an average return of 8% to 10% in the long term, it doesn’t guarantee this every year. Some years may have returns of +30% or -30%, and past performance also doesn’t guarantee future returns.

Investing in the stock market requires enduring volatility and psychological pressure.

Remember the time of the 2008 financial crisis? The market dropped 50% in general. To be honest, how many people do you think could handle seeing their hard-earned assets nosediving without panicking and cutting their losses?

Borrowing money for investment adds to the psychological pressure, particularly when you have to make monthly repayments. Can you guarantee that you can withstand a market downturn when you have borrowed money? Or will you give up and cut losses during a decline?

Having that in mind, stay alert to potential risks before you make any moves!

9 investing principles that you should take note of

Borrowing money for investment isn’t necessarily a bad thing, but it depends on individual financial knowledge, conditions, and cash flow. So here, we’re going to talk about the optimal conditions under which borrowing for investment is feasible.

1. Sufficient understanding of the investment

The first prerequisite for borrowing for investment is having a good understanding of the investment. Well, if you have to ask others what to buy, or following trading signals, then borrowing for investment is not the right choice for you. 

And of course, choosing investments with the potential for positive returns is essential, but it’s crucial to not only focus on the returns. We also need to understand that there are inherent risks and uncertainties involved, like estimating the worst-case scenarios and the extreme volatility.

2. Stable cash flow

Having a stable cash flow involves diversifying your income sources instead of relying solely on a single source. For instance, depending on one’s salary, income can be risky if that source becomes unavailable.

To ensure a more secure cash flow, it’s better to have multiple sources of income, such as combining a couple’s salaries with passive income like rental earnings. By ensuring that your total cash flow exceeds the monthly loan repayment amount (at best 3 time more than your monthly repayment,) you can lay a more stable financial foundation.

3. Keep the monthly repayment below 1/3 of your income

Keeping your monthly mortgage payment under 30% of your income ensures that you have enough room to cover the rest of your needs. This is a rule similar to the 30% rental payment to make sure you’re able to repay the loan.

4. Low loan interest rates and long repayment periods

If your cost of capital is high, it’s best to avoid borrowing for investment, as the risks may outweigh the potential returns.

Low loan interest rates can refer to rates around the time deposit rate + 1%, or relatively cheap mortgage rates. For example, if the current one-year time deposit rate is 1%, the loan interest rate should not exceed 2%. (And mortgages are among the few loans with favourable conditions, such as lower interest rates and longer repayment periods.) With such low interest rates, you have a better position the make arbitrage between the returns and the interest rates. 

What about personal loans?

For personal loans, it is not recommended unless you have excellent conditions that offer mortgage-like interest rates and strong cash flow. Borrowing at 6% to 8% interest for personal loans would likely consume most of your profits. Unless you are confident that you can quickly end the investment and avoid excessive interest payments, this type of loan is not cost-effective in terms of both the loan amount and interest.

A longer repayment period is needed

Avoid loans with short repayment periods in addition to low interest rates. Repayment periods of less than 3 years are particularly risky as they increase monthly cash flow pressure and amplify the damage caused by investment risks, potentially trapping you in a dangerous short-term support situation.

5. Avoid high-risk investments

Some people borrow money for investment and then use it to trade high-risk derivatives such as futures, which is essentially gambling. However, this often leads to them losing all their capital and accumulating debt.

If you are considering borrowing for investment, it is recommended to focus on long-term, diversified assets with lower risk. For example, investing in broad-market ETFs or funds and high-quality bond ETFs or funds is a better option than investing in single stocks or high-risk asset classes.

Only opportunities with a high success rate and certainty are worth the risks associated with leverage.

6. Strong psychological resilience

Before investing, consider whether you can handle the worst-case scenario, such as a 50% drop within a year, without panicking. And let us remind you again: Borrowing for investment may not be suitable for everyone. It requires having sufficient psychological resilience and a through planning of risk management.

7. Prepare an emergency fund

It’s always wise to prepare an emergency fund that covers 3 to 6 months of living expenses. (Don’t forget to calculate the monthly repayment if you are taking out a loan.) So, in case of any disruption to your income, You still have time to adapt to the sudden changes.

8. Be clear about your financial status

This means that you need to have a clear understanding of your income, expenses, assets, and liabilities. Assess your financial status as a company, and always settle existing debt first. This is the essential step to building your wealth. It is also recommended that you make your own financial statement with assets and liabilities to keep track of your financial health.

9. Go through the terms and conditions

Be aware of the risks involved in the investment before borrowing, including the risk statements and terms and conditions of the investment products, and especially try to understand the hidden costs, such as late payment charges, prepayment charges, processing fees, etc.

Tax loans can be a good option

If you’ve made up your mind to lend a loan after reading this, you might consider getting a tax loan during the tax season as tax loans products are rolling out to the market with a low interest rate. It is always a good idea to shop around for the best possible rates in town (which can be as low as 1.78%!)

However, do note that not everyone is eligible for the lowest tax loan rate, as seen in advertisements, because it depends on the loan size and the applicant’s financial situation.

To find out more, you can check out the following article:

Here are a list of tax loan products that offer a low interest rate and up to a 84-month tenure:

Citibank Speedy Cash Loan: Interest rate as low as 1.78%

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Valid until 31 May 2024

WeLend Personal Loan (Available for tax season): Borrow up to 84-month loan term

Promise Personal Loan (Available for Tax Season): Only HKID and mobile phone required

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