When you hear of friends and family making a quick buck (or big buck!) in shares and the property market, it’s easy to want in on the action. While we all want to get some skin in the game, we’re often without the means to get started.
So, the question is, is borrowing to invest in shares a good or bad plan? Is it worth getting a loan to get into the game that could make you wealthy?
Well, it’s not as easy as a yes or no answer. We’ve got a lot of things to consider before genuinely figuring out the best path forward, and that’s what we’re going to look at in this article.
Borrowing to invest is risky; first, we must understand how it works.
It shouldn’t come as a surprise that using borrowed funds to invest is very risky, but you can do many things to reduce risk and make it a worthwhile venture.
First, let’s quickly dive into types of borrowing to invest.
A margin loan is a risky move when it comes to investing. Margin loans allow borrowing money to invest in exchange-traded shares and managed funds.
Most lenders will require you to keep the loan-to-value ratio, also known simply as LVR, below a certain level to which you’ll agree beforehand - it’s commonly below 70%.
You'll receive a margin call when the LVR is above agreed-upon levels. A margin call gives you 24 hours to lower the LVR by either depositing money, adding shares, increasing portfolio value, or selling parts of your portfolio off to pay a portion of your loan balance.
Here’s what you need to do to manage these risks:
- Set borrowing limits that you can comfortably repay. Whatever the result of these limits is, stick to them.
- Loan interest repayments should be made regularly to ensure the loan balance is within manageable limits.
- You should check your LVR constantly and consistently. Why? Because the value of investments falls and rises quickly, receiving unexpected margin calls is never a good financial situation.
- Always have the funds ready to deposit if the lender makes a margin call that opposes your desire to keep your shares.
- Never use things like home equity or your rental income as loan collateral. You should always be able to cover a margin call with your money if markets fall or rise (against a short position).
Property investment loans
A property investment loan can be used to invest in homes, apartments, land, and commercial properties. Similar to how margin loans work, you’ll need to ensure you can pay back interest regularly to maintain a manageable loan balance.
You’ll be able to collect rent money as investment returns which will pay mortgage interest and property management/ownership costs.
This is less risky than a margin loan but still carries risk as an investment property is exposed in the event the market falls or interest rates rise due to the Reserve Bank of Australia’s strategy.
In the long run, those who buy the property and utilize tactics such as negative gearing have done quite well, but past performance is never indicative of future performance. Multiple issues can arise from property investment loans and owning property in general.
For example, you can suffer from bad tenants, interest rate hikes, vacancies, declining property values, and many more obstacles.
You need to navigate these potential risks as they arise and always be prepared for anything.
Here are some risks involved when borrowing to invest.
Depending on your loan, this might not be an issue but one loan, known as a variable rate loan, has interest rates that can increase or decrease.
You need to be aware of the potential for interest rate hikes and determine if you’d be able to pay the monthly interest if it were to go up by a few percentages.
As we’ve seen recently, the Reserve Bank of Australia has raised interest rates by 3.10% from historical lows of 0% during COVID, even after explicitly saying they wouldn’t raise rates until 2024 - a claim Lowe has said was never concrete and always conditional.
This is a prime example of how you always need to be prepared for changing plans, particularly if you embark on more significant investments, such as a home loan or starting a share portfolio. Many Australians are now feeling the pinch of these added interest expenses.
The values of investments are never set in stone. They can change for better or worse, like interest rates on variable loans. When discussing risk, it usually means that investments can depreciate.
If you’re ever in a position that requires you to sell an investment quickly, then this loss in value can result in you being unable to meet the loan repayment balance.
When you’re using borrowed money to invest, an investment that doesn’t pan out can be a significant loss. Regardless of how the investment pans out, you’re still on the line for the loan repayment of both the initial amount and the interest.
So, when your investment falls due to market volatility, you lose much more than the money you initially invested. This is why borrowing to invest in such a high-risk strategy.
Investment income risk
If you’re investing in something meant to provide an income, ensure you’re able to meet loan repayments should you experience a downturn.
For example, with property investment, you’ll sometimes have moments where the property is vacant, or you run into unplanned expenses for which you must pay - for instance, the tenant notices asbestos or mould - you are legally required to remove these dangerous materials.
Keep some money (perhaps income earned from your investment) on the side to cover these financial hurdles. Remember, these expenses are tax deductions that can reduce any capital gain tax you’re obliged to pay on your investment property.
How do I manage the risks associated with borrowing to invest?
Just because something is risky doesn’t mean it’s impossible to make it work. Here’s how you can manage risks that are associated with borrowing to invest:
Pay the interest
The last thing you want is to mess with interest owed to your margin lenders. Make sure you meet monthly interest repayment requirements, and if possible, throw a bit extra when you pay interest to lower the monthly payment requirement.
Always have extra cash on the side ready in case
It’s wise to have an emergency fund set aside to cover interest/loan repayments to ensure that even in bad months, you’ve got the loan covered. You don’t want to sell off your investments to repay the loan, so make sure that doesn’t need to be a concern by stashing more cash than you think you need on the side. It’s never a bad thing to be over-prepared when you’re dealing with borrowed funds.
If you spend emergency funds, try to repay your rainy-day fund ASAP.
Keep a diversified investment portfolio
Don’t throw all your money into one type of investment. Instead, diversify your investments to ensure that if one investment doesn’t work out, that doesn’t mean your entire portfolio has collapsed. A helpful exercise is to ask yourself hypotheticals.
For example, would your hand be forced if the property market suddenly turned for the worse? If the answer’s yes, you need to rebalance your share portfolio or investment fund and perhaps look at another asset class to invest into.
Look for the best investment loans
You’re probably already profoundly connected to a financial institution you’ve used for a long time. While there’s nothing wrong with getting a loan from that financial institution, you should always shop around and see what else is out there - remember, lenders want your business - you are in the driver’s seat.
By looking next door, you can lock in better margin rates or be in touch with a reputable financial adviser to help you better manage your existing share portfolio! Always take the time to learn about the other options available and how some might be better in the long or short term.
Don’t get the highest-valued loan for no reason.
You’ll get all kinds of offers, but one thing remains essential regardless: don’t get the maximum amount offered. When you borrow a lot of money, you have higher interest repayments. This translates into a higher risk of potential losses.
What are the benefits of getting an investment loan?
Immediate cash influx
The most apparent benefit of investment loans is that you’re given an immediate cash influx, allowing for investing. Sometimes good investors are unable to flex their financial muscles due to issues raising capital. Getting an investment loan opens you up to potential investment opportunities.
Investment loans are a form of ‘good debt’
You're participating in good debt when you take money to get things that will increase in value. What this means is that things like property, have the potential to make more money than they initially cost, and that can result in the form of good debt.
Leaping for opportunities that you know will work out long-term
Whether it’s emerging markets or a start-up that you know has the potential to be worth a lot of money in the future, investment loans free you up to get in on the action. An investment loan allows you to cling to new opportunities in their infancy.
Investing in their future allows you to make significant financial gains. Of course, it’s important to remember to diversify your investments, especially if one isn’t going to make you money for a couple of years.
Most investment loans require interest-only payments
That’s right. You’ll be allowed to pay back the interest on the loan for a certain period but not the initial loan amount. This gives you a grace period of cover to make more money to invest further.
While you pay the interest, you build your portfolio to the point where you’ll be able to pay off the loan without any issues.
So, if you made it this far, you’ve been thinking about borrowing to invest in shares. We recommend considering this option only if you are an experienced investor and know all the potential risks! If you’re new to investing, we’d strongly encourage speaking with a financial adviser with a proven track record of capital growth and managing investment income.
With our loan opportunities, you’ll be connected to numerous experienced lenders with a lot to offer. When you feel ready, check out our personal loan options today and find the right loan with Driva!
What is it called when you borrow money to invest in stocks?
When you go with borrowing to invest in shares, you usually take an investment or personal loan, depending on how you do it. However, the main idea is called gearing or leveraging.
You’re using money and putting it into a financial odds game of making educated guesses about which company/stock will thrive and which will die. Through this, you can increase your wealth or lose everything in the process significantly. Thus making the concept of borrowing to invest in shares a risky business.
Is getting a margin loan risky?
Yes. They are one of the most convenient and valuable loans, but as predicted, they come with their fair share of risks. Some risks associated with margin loans are interest payments, reduced flexibility on future income, leverage risks, and margin call risks.