17

With the recent economic struggles due to the Covid-19 pandemic the stock market seems to be even more interesting for personal investments. Taking out a loan might be one of the ways to gather or boost the available assets.

I did a quick back-of-the-envelope calculation: I checked with my bank, I can get a credit for 20k EUR with a basic rate of interest of around 2.9 % p.a. for a credit period of 5 years. Including interest and fees I will have to pay back 21.7k EUR, amounting to an actual interest rate of around 3.8 % p.a.

Following this I checked the stock market for (rather) conservative investment options, and therefore considered the following products:

  • Government bonds
  • ETFs

My country, which has a Moody's rating of Aa1, issues (among others) bonds with interests of around 4.8 and 4.5 % p.a. with remaining bond periods of 5 or 6 years. Including fees and taxes the effective interest rate should still be in excess of 4 %, therefore being able to cover fees and interest of my loan as well as granting a small profit.

I can also put the money into an ETF (e.g. IE00BKBF6H24), which has a certain risk associated with it, but with a good chance to outperform the actual interest rate of my loan, maybe even significantly.

Is this a legit approach? If yes, which (maybe temporary) factors contribute to it?


Edit: I've misinterpreted the government bonds situation. There are bonds with such high interest rates, just not from countries with an Aa1 rating, as some of you have already clarified. Thank you for that.

44
  • 5
    Then you won't be able to invest the whole 20K for 5 years. You'll either have to fund repayments to the loan separately or sell your investments gradually. The back of your envelope needs to have more room for the corrected calculation. – Robert Longson Jan 12 at 8:41
  • 5
    Well you could have invested your basic work income directly in the stock market instead. You'd need to check whether that was more profitable. Maybe you just need a bigger envelope altogether. – Robert Longson Jan 12 at 8:55
  • 7
    Are the bonds denominated in EUR? An interest rate of >=4% on EUR bonds in today's world sounds highly unlikely unless your country is a huge credit risk. – GS - Apologise to Monica Jan 12 at 11:51
  • 7
    @pat3d3r from: boerse-frankfurt.de/bond/… it looks like you are confusing the face coupon rate (confusingly listed as interest rate) with the rate that you would get by buying the bond now. That is only true if the price is 100. In this case the price is about 128.94 so paying that much your effective interest rate (the yield) is -0.6639% (using last prices) does that change your decision making? – MD-Tech Jan 12 at 12:36
  • 3
    You mentioned paying fees and taxes in the calculation of the profit but did you include any type of capital gains tax your country might have? It seems like Germany has a 25% tax on profits like this (I could easily be wrong) which would reduce your nominal profit of 4.8% well below 4% and that's ignoring any other fees you might have to pay. – Eric Nolan Jan 13 at 17:37
36

Any scheme of borrowing money to "invest" is in fact a gamble and should be avoided. Stick to your own money for investments.

Nobody can predict the market and neither can you. 4% interest rates for a government bond sounds like a banana republic given the amount of money central banks are pumping into the market to buy government bonds. Even worse, your assumption of risk-less interest is severely flawed. There are already open thoughts about defaulting. Of course they do not call it defaulting but rather package it nicely by "encouraging" the central bank not to insist on repayment. But this is effectively defaulting on debt.

Similar goes for investing borrowed money into an ETF. Stock markets are at an all-time high despite a pretty bad fundamental situation with lockdowns likely to go on for months. Nobody knows what will happen next. Maybe this is just reflecting inflation after the money printer went crazy in 2020 and this is the "new normal". Maybe this is just a huge bubble and we will see wholly different prices in a year.

Think about the case where your loan will be due and you have a substantial loss. Can you cover this by savings? Likely not, because then your savings would be used for the investment directly and not borrowed money.

Note:
I am aware that the opening statement is a blanket rule and there are valid exceptions to this rule. However, the gist of it holds true. Unless you really know what you are doing, do not borrow money for the sole purpose of a volatile investment

39
  • 20
    "Any scheme of borrowing money to "invest" is in fact a gamble and should be avoided. Stick to your own money for investments." I find this logic flawed. If someone has a mortgage should they not invest until it is paid off? Every dollar they invest while having a mortgage is essentially a borrowed dollar. – Hart CO Jan 12 at 17:39
  • 9
    @HartCO Investing earned wages in the market during the years you are paying on a mortgage is one thing. Actually taking on additional debt for no other reason than to invest in the market is quite another. – Ross Presser Jan 12 at 18:57
  • 23
    @RossPresser Can you tell me how it's different? If you invest money instead of paying extra toward your mortgage it is equivalent to borrowing money to invest (at the same rate as your mortgage). There can be tax-nuances that shape the decision, and I'm fine with the notion that it might be a bad idea, but the blanket statement I quoted is flawed. – Hart CO Jan 12 at 19:20
  • 12
    While the risk is much higher margin investment is normal and not "flawed" at all. – Matthew Whited Jan 12 at 19:23
  • 19
    @RossPresser If you have $100 extra each month and you have a mortgage at 3%, the decision to invest that $100 instead of pay extra towards the mortgage is the decision to pay 3% interest on that $100 in hopes of getting greater returns through investment. If someone has $200k cash and wants to buy a $400k house, they could put down 50%, or they could put down 20% and invest their cash, that is borrowing to invest as well. Saying that "any" borrowing to invest should be avoided is saying that you shouldn't invest unless you have no debt. I don't agree, I think more nuance is needed. – Hart CO Jan 12 at 21:11
24

Personal rule for borrowing money in order to 'invest' in any kind of generally available thing:

Assume your investment will lose all of its value and you lose your job and need to live off your savings for 6 months to a year while still repaying the debt. (If you think losing its value is unrealistic, then assume the brokerage goes bankrupt and it takes 5 years for them to sort through the mess and finally release your assets back to you).

In that scenario, are you OK?

If yes, then consider the investment.

If no, then don't even consider it in the first place.

If you were genuinely being offered lower interest than the rate on your own government's bonds then this would be more interesting as that's pretty close to arbitrage territory, but you've already indicated that's not the case.

And, in fact, it should never happen in real life. Because if it did, why would a bank loan you the money when they could loan it to the government instead and get higher interest with a better chance of being repaid?

13

Is it risky?

One of my colleague's answers reads "Any scheme of borrowing money to "invest" is in fact a gamble and should be avoided."

That sentence is not really correct.

ALL trading is a gamble.

It's more like this: "you are risking losing cash you don't have".

  • Say I have a million bucks cash. I also have a job to live off. It's 1988. Every single living human in the world agrees that the Japanese stock market is about to start a huge boom, so I put the $1m in to the Nikkei. From there it went straight down for 20 years. So I have now lost all or most of the cash. I have no cash. At least I still have the job to live on.

  • Say I have a house worth a million bucks. I also have a job to live off. I get a loan on the house for a million bucks, and invest it in the Nikkei, and I lose all the money as above. The problem is I now OWE a million bucks on the stupid house.

You can see that "B" is, in a sense, much worse.

HOWEVER ... that being said, note that in "B" I can then simply sell the house, and pay off the million bucks. So ....... it can be naive to say "B is absolutely worse and stupid".

Indeed: there's a serious danger in thinking that "A" is "less risky".

The fact is this:

trading anything risks you losing heaps of value. You can either "lose your house" (if you get an interest-only loan on it to gamble with) or you can "lose all your cash" (if you simply gamble with your cash).

I can assure you that when you make a big swing trade, and lose a few hundred thousand in cash, you do not feel smart. I have fortunately never lost a pile "on a house" but my guess is that would also suck.

I think the overwhelming takeaway is:

  1. Sure, what you describe is completely commonplace, people do this all the time with assets

  2. You do have to realize you can lose.

12
  • 2
    "example, "Warren Buffett", an epic loser, approaching 100 billion with a B so far" Where is this from? I see Berkshire Hathaway returning 17%/year avg since 1985 as of 2019 data, this past year will drop the average a little bit. – Hart CO Jan 12 at 16:13
  • 3
    @HartCO: That bit alone should be a warning about the whole answer. If stocks are causing that much losses, why do rich individuals, pension funds, sovereign wealth funds, university trust funds etcetera all continue to invest in that market? Wouldn't the more likely explanation be that this answer is just wrong? – MSalters Jan 12 at 17:12
  • 1
    the (correct, major news item) example of "some trader losing a fortune" is of no consequence, I just deleted it. – Fattie Jan 12 at 17:19
  • 1
    @trallgorm - we rock :) – Fattie Jan 12 at 17:26
8

Think about it this way, the bank would rather trust you to pay back the loan with interest instead of denying you the loan and engaging in the scheme themselves.

They probably use larger envelopes for their math...

4
  • 1
    Yes, but while there are certainly some similarities, banks surely have different circumstances and probably even motives than the average Joe private investor. At least in my opinion. – pat3d3r Jan 13 at 11:45
  • Don't banks get money from the government specifically to be used for mortgages? In that case their hands are tied - either make money from giving loans for mortgages or don't take part at all. – cjnash Jan 14 at 20:46
  • 1
    @cjnash My understanding has been that local banks secure a qualified borrower and supply funding for the transaction. The bank can then choose to keep the loan till maturity or they can sell it to a larger agency such as Fannie Mae or Freddie Mac and earn a profit without having to wait 30 years. I'm sure this varies slightly from bank to bank especially when comparing large vs small banks. – MonkeyZeus Jan 15 at 13:47
  • @pat3d3r Correct, banks know to diversify; taking out $20k to let it ride on stocks is far from the former. – MonkeyZeus Jan 15 at 16:35
5

I, for one, am rather confused by your calculations. According to my noob-friendly financial calculator, for a 20K investment to reach 21.7K in 5 years it needs to have an annual equivalent rate (AER) of just 1.64%.

You seem to be able to borrow at very good rates, and the idea of using some kind of leverage to supercharge one's investments during raging bull markets is not a particularly original one.

I don't think European quality debt will default, or rather will be allowed to default, so that bet is most likely a safe one.

The one on the MSCI World index is not.

Based on its track record (to be taken with a pinch of salt, because "past performance is no guarantee of future results"), as far as I remember it (I don't have the numbers at hand) if you had invested in Oct 2007, you would have managed a painful recovery all the way to those levels (in EUR terms) only in Jan 2013, and this is assuming you had not panic sold in the meantime.

Also, as you plan to pay back your debt by using your primary source of income, bear in mind that your employment may react procyclically to economic shocks. In other words, you may end up in a trifecta where your broad market ETF is down 45% and won't recover any time soon, you have lost your job, and you still have to pay back your loan.

3
  • Thanks for your input. Your last point is rather important, and one of the reasons I did not straight out proceed with this plan. It is definitely a calculated risk, even with a moderate investment strategy like ETFs. – pat3d3r Jan 12 at 11:29
  • The interest rates for the loan calculation are from the bank sheet. Your numbers are lower, as are the ones of my own calculation, but I stuck with the higher values for this example. The loan itself is still subject to discussion, of course. – pat3d3r Jan 12 at 11:43
  • 1
    As I mention in the comment up top, obviously you can only do this if it is an interest-only type loan (which more or less exists for that purpose) – Fattie Jan 12 at 15:04
4

Borrowing money to make an investment is called leverage. If the interest rate of the borrowed money is less than the return on the investment (considering of course all taxes and fees) then it is a profitable proposition.

Leverage is common in investing, though perhaps not in the specific way you describe. Some examples:

A widget factory might issue a bond to purchase an automated widget machine. They believe the return they will get in investing in the machine is greater than the interest they will pay on the bond.

Many brokerage accounts offer a margin account, which is effectively a loan the brokerage gives you, with your assets at the brokerage as colateral. The brokerage can lend you cash which you can use to buy more shares of a thing you believe will increase in price, or you can have the brokerage lend not cash but securities. You can then sell them to someone else, then buy them back later at a lower price and repay your loan. This is called short selling.

An individual that has a mortgage on their home may choose to invest some excess income in the stock market rather than paying down the mortgage balance. This is effectively deciding to pay more interest on the loan for a chance at making returns to cover that interest and more in an alternative investment.

Leverage multiplies gains, but it also multiplies losses. Additionally, it adds expenses of its own because the creditor will want to be compensated with interest on the loan. That interest diminishes your returns.

As such, leverage also increases risk and volatility. Before deciding to leverage your investments, you should think about the risks. Without leverage, you can't lose more money than you initially invested (the "cost basis"). But with a leveraged investment you can lose more than that. Your investment can lose all its value, and you still have to repay the loan.

Consequently you'll find more leverage in situations where there are limits on liability. For example, startup corporations are often extremely leveraged. They can do this because the liability of the corporation doesn't extend to the personal assets of the shareholders. If the company fails it can declare bankruptcy and the shareholders still have their home. For an individual however the stakes are higher: you could lose all your assets.

If you've duly considered the risks and still want to leverage your investments, I'd suggest looking for other ways to accomplish it besides what you've proposed. Your bank will probably want something for collateral, like your house. Or, they may be able to garnish your wages. You shouldn't risk more than you can afford to lose. Can you afford to lose your house or your income?

Instead, see if your broker can offer a margin account. Check the details, but in most cases the broker's recourse is limited to liquidating the assets in your account. This way you have some bound on the worst case outcome that doesn't leave you homeless.

In general though, I wouldn't recommend leveraging your investments as an individual. Keep in mind that anyone can do what you are proposing, and so if it truly was a "can't possibly lose" strategy, everyone would do it. This would then mean banks would have high demand for loans so they could charge more interest, and companies seeking investors would have many people offering them money, so they could get away with lesser returns. This dynamic creates pressure for the bank's interest rate and the return on investment to converge, making this scheme less profitable.

So if the market is efficient, the risk adjusted return of your loan and your investments should be the same, so by investing in this scheme you are betting that the market consensus has misjudged the risk of investing in the stock market or loaning money to individuals. If you don't have any particular data to support that view, then it is not a prudent investment.

2

I didn't see the numbers themselves analyzed in the other answers. Do you understand that according to your own estimates you would likely be earning below 5 EUR per month?

Including interest and fees I will have to pay back 21.7k EUR, amounting to an actual interest rate of around 3.8 % p.a.

My country, which has a Moody's rating of Aa1, issues (among others) bonds with interests of around 4.8 and 4.5 % p.a. with remaining bond periods of 5 or 6 years. Including fees and taxes the effective interest rate should still be in excess of 4 %, therefore being able to cover fees and interest of my loan as well as granting a small profit.

Let's assume your best scenario. You take money at 3.8% fee and invest it on 4.8%. 20k EUR that you have to return at the end of the period. So you gain 1% per year. That is 200 EUR. I would say that this number is small enough to just not bother with this hustle/hassle.

Let's get more realistic. You have to return the debt continuously, so on average throughout the period you will have 10k invested. You also estimated that because of fees and taxes you would get less, but "in excess of 4 %". Would 4.3% be fair estimate? We've now halved your investment and halved your margin. 50 EUR per year. 250 EUR total. Below 5 EUR per month.

Are you willing to go through all of that hassle for 250 EUR? Are you willing to log into your account each month to sell a small amount of your investment and return the debt? For 5 EUR?

1

"Never invest anything you aren't comfortable losing" is some of the best financial advice out there.

If you lose everything, are you ok? Will you still have a house, food on the table, will your relationships endure the strain, etc.?

If your investment is borrowed money, then losing everything doesn't bring you down to $0, it brings you way past $0. That's why all the investing forums fill up with suicide hotlines whenever the market dips. You don't want to end up in that kind of situation.

4
  • Doesn't that advice imply we shouldn't borrow to buy a house? Most people aren't comfortable losing their house, but most people who buy houses borrow money to do so. Is that unwise? – gerrit Jan 13 at 8:55
  • @gerrit Yes, it's unwise, and the fact that people are forced to borrow to buy a house (or choose not to have a house) is partly because other people chose to do so in the past... – user253751 Jan 13 at 15:38
  • @gerrit if you can't pay for the house, then you give the house back, so your end state (no house) is the same as before the investment (no house). So in that sense it's not as bad as e.g. losing the house but keeping the debt for it—which is what happens if you borrow to buy stocks that plunge to nothing – Mirror318 Jan 13 at 21:43
  • @Mirror318 Sure (unless it sells for less than the remaining debt); but as stated in this answer, we shouldn't invest the house. – gerrit Jan 13 at 22:19
1

Depends, how easy is it to discharge the loan you mention?

How certain are you that you will best the interest required? How would you arrive at your conclusion?e.g. What research have you done and why do you believe this is enough?

What are your plans if your investment loses in value? How much could your investment most likely lose? 10% of principle, 20%?

For the answers that say what if you lose everything. I have not seen many broad ETF's loose everything. Oh no, the sky is falling.

So if the market is efficient, the risk adjusted return of your loan and your investments should be the would be true but it is not efficient. There are many entities that are not permitted to do as you suggest by law. There are many who believe oh no I might loose everything.

P.S. Stop-loss is your friend.

P.P.S. My doctor did something similar. He was offered 0% credit card cash advance, bought a CD at 3%. cha-ching. But if the market was efficient, he could not do this, thankfully, it's not. Some people will take the cash advance and by a new car. Nothing like a depreciating asset.

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.