Borrowing to invest if done correctly can magnify gains. However it’s a double edged sword, it can also magnify your loses. Any investment that has the potential to earn you lots of return also should have the potential to lose a lot of money for you. If someone says otherwise, I recommend you get out :). Important concept here is your risk tolerance. Let’s take a look at an example.
If you borrowed $100 000 @ 6%, and earned a return of 10% on this money this would be your return. Remember interest expense on an investing loan has a tax advantage.
i.The cost of your debt is 6% which equals to $6000, however you only pay in interest, interest expense * ( 1 – marginal tax rate). Let’s say you are in a 40% marginal tax rate, than your interest expense on the 100k would be :
• 100000* (.06)(1-.4) = $3 600
ii.The return on your investment was 10% of 100k which equals to $10 000. If all of the $100 000 was your money , and you had a 10% return than your rate of return is 10%. In this case the $100 000 was not your money, you borrowed it to invest. Your cost was just the interest cost of $3 600. In this situation your rate of return is : ( 10 000 / 3600 ) * 100 = 278%
iii.How about that ? 10% return versus 278 % return 🙂 .
The above scenario has a downside as well. If you had a bad year and lost money resulting in a -10% return if all of the $100 000 was not borrowed money, than your rate of loss is -10%. However if you had borrowed the $100 000, than your rate of loss now jumps to -278% :).
Debt/Leverage if used responsibly can help increase your capacity to earn returns. The key concept here is “ if used responsibly”. Now, what does that mean?
1. Only use debt for investing if you can tolerate the risk. If there is a queasy feeling in your stomach at the thought of using debt for investing, that’s a sign to stay away from it
2. The 10% return on the example is not an easy amount to attain. On average Majority of mutual fund managers don’t hit this return. So you need to have an understanding of what is the average type of return for the asset class you have invested in. That’s a good starting indicator for the type of return you can expect.
3. Only borrow to invest, if you have the capacity to service the interest and principle, and have the capacity to take on a reasonable amount of loss on the borrowed principle without pushing you in to financial distress territory ( fancy term for bankruptcy) . If you are already carrying a lot of debt, taking on more debt to invest is not a good move for most people. Wait till you have gotten rid of some of your debt, than look into using debt for investing.