Borrowing to invest in stocks may not make sense but consider this other type of investment
One of the most common questions I get from readers is if you should borrow to invest in stocks.
I’ve been pretty vocal about not using margin to invest in stocks. That’s when you invest more on the online platform than you have in the account, usually at interest rates of 8% and higher.
In fact, not using margin is one of the ways investors can win the stock market game and not make the big mistakes that lose money.
But with interest rates on other types of loans touching historic loans, does it just make sense to borrow to invest?
Turns out, there may be one investment where it pays to use borrowed money but there’s a catch.
Don’t Borrow to Invest in Stocks…but Consider This Investment
Borrowing to invest in stocks is too much of a gamble for me. Sure, stocks have returned around 7% over the long-term but can be a roller-coaster over shorter periods. Bad investor behaviors and a stock market crash led to an average investor return of just 2.6% annually over the decade to 2013.
The fact that investors can’t seem to get over buying high and panic-selling when the market crumbles makes stock investing on borrowed money a bad idea. Even if you could borrow money on a 15-year refinance on your home, you would just barely be breaking even on a 2.6% return.
Some of the answer to whether you should borrow to invest comes down on what types of loans you can get. Taking out a personal loan with a double-digit interest rate to invest doesn’t make much sense but locking in a 2.7% fixed rate on a home refinance loan gives you much more room to earn a higher return.
If you can cash out equity in your home at an interest rate below 3%, it might make sense to borrow to invest in stocks…if you can keep from buying and selling constantly. That’s a big if and one that most investors would be better off avoiding.
There is one scenario that might make more sense borrowing to invest the money.
Peer loans through Lending Club are investments in personal loans to individuals. These are like bonds except to people rather than to corporations. Interest rates are much higher and returns range from 5% up to 12% for diversified portfolios of loans.
There is a small market for buying and selling old loans but few are using it. For most investors, investing in a peer loan means they are locked into the investment until it’s fully repaid in three to five years. That keeps investors from jumping in and out at the wrong time and means average returns well above other types of investments.
I recently reviewed three peer loan investing strategies for different types of investors, strategies for safety and solid cash flow.
Reasons You Should Not Borrow to Invest
There are more reasons not to borrow to invest and the answer for most people is probably a flat-out no.
If you don’t have much equity in your home, you’re not going to get much out of a refinance or home equity line of credit. Any type of unsecured loan or credit card advance is going to be at a rate that wipes out any gain on investments.
If you’ve already got high-interest rate debt on credit cards or other loans, you may want to consider a debt consolidation loan to lower your interest rate. Paying down high interest rates should be your first consideration ahead of investing because the difference on your consolidation loan and high-rate debt is a guaranteed savings.
Whether you should borrow to invest isn’t always as clear as you may like but that doesn’t mean the question can’t be answered. Besides just the difference in the loan interest rate and the return you are expecting, think about the risk around the investment. If there is risk that your return won’t cover the loan interest by several percent, is it really worth the headache?