Life has taken a funny turn for me in recent months. I find myself, debt-free with the starts of an investment strategy. I am spending my days doing work I absolutely love and, though there isn’t a lot of spare money lying around (and, by that, I mean I recently paid for a cup of coffee in ten cent pieces), I can see the beginnings of the life I want to lead.
Yet, as always, there are things I can’t do due to financial reasons. Overseas travel is conclusively out. Living anywhere but a shack, likewise. So, in considering my options, I thought about the many wealthy people out there who have borrowed money to invest. Could this be an option that works for me? And what does it entail? Here are some of the tips and tricks that research dug up, derived from Choice and the Sydney Morning Herald articles.
People borrow to invest to give their wealth creation an extra boost. Money makes money, so having a greater amount of capital inevitably generates more wealth, both in a capacity to take advantage of financial opportunities and in the power of compound interest. So it’s simple right? Think again.
What Can You Borrow?
Margin loans offer a percentage of your investment, termed a loan to value ratio. Like a mortgage, lenders will provide a margin, usually somewhere between 30 to 70% of your investment. So if you’re buying $100, 000 worth of shares, a lender could provide between $30,000- $70,000.
What Is The Security?
Obviously, lenders are not going to provide the money without some kind of security. Usually, your loan is secured against other investments or against the investment itself. The great risk in borrowing to invest is that the value of your investment falls, and you are now up for a ‘margin call’. Here’s how it works. You borrowed 70% of $100,000, so $70,000. Your investment’s value has now fallen to $90,000, which means you are only entitled to 70% of that figure, or $63,000. In other words, your lender is going to be calling you to make up the difference in the loan which, in this example, is $7,000.
This is the greatest risk of a margin loan, or borrowing to invest. That the value of your investment falls and you don’t have the financial capability to pay back the difference, and are therefore forced to sell at low prices. You’re now doubly at a loss, both out of pocket and without an asset with which to earn the money back.
Who Can Borrow?
Which leads to the essential criteria should you be considering a loan. Yes, comparing rates, doing intensive research on your investment and exit strategy are essential. But the most important research you should be doing is on your own capability to borrow for an investment.
If you have extra money to pay back the interest of the loan, a steady job and a plan to repay the loan should you lose it and a long-term investment strategy, then borrowing to invest is an option. These are no small things- your finances will have to be rock-solid before considering it, as you’ll have to have extra resources to cover margin calls should the investment value drop, and a financial buffer to absorb drops and wait for the asset value to improve.
If the sub-prime mortgage catastrophe has shown us anything, it is that personal responsibility and realistic appreciation of our finances are necessary when it comes to loans. Of course, lenders had a massive responsibility, and they blew it. Yet that shouldn’t exclude us from being sensible about our own capacity to manage a loan. After researching borrowing to invest, I know I am still a long way from being financially able to manage a margin loan. Certainly talk to a professional advisor should you be considering it.