Updated: November 5, 2020
A friend asked me if it’s a good idea to take out a personal loan and then use the money to invest in the stock market.
He shares that he can borrow money at 1.2% interest from his bank. And since the stock market earns more than that, then he can pay for the loan and still have extra money left as profit.
Do you think that’s a smart money move? He’s basically trying to leverage debt, which is actually a common investment strategy.
I congratulated him on coming up with this plan because it makes sense if you think about it. However, I encouraged him to simulate the loan and investment cashflow to check and see if it really works.
Because from experience, the best way to know if an idea is good or bad is to run it on paper, especially for financial plans and investing strategies.
Working the Numbers
First, I told him that the 1.2% interest is per month. And according to the terms of the loan, the offer is really for a fixed annual interest rate of 14.4% (1.2 multiplied by 12) for a 1-year term.
So if he borrows P50,000 at a fixed rate of 14.4% per annum for 1 year, then he’ll need to pay around P4,767 per month for 12 months.
The challenge now is if he can cover that payment per month. And this means he should get an absolute return of at least 2.14% per month from his capital just to breakeven.
Below is an illustration of how the cashflow will happen.
Realizing gains of 2.14% per month in the stock market is possible. But the question is does he have the knowledge, skills, and experience to achieve this?
My friend has been investing and trading the stock market for a little over a year now. So I asked him how much he makes per month on average.
He said it’s been inconsistent. Some months, he’d have as much as 15% returns. But other months, he’d experience around 10% in losses. Although he estimates he gets a return of around 3% per month.
I emphasized that because stock market investments are volatile, then he needs to be prepared for those months when he’d have negative returns. Particularly, he should have another source of funds to pay for the P4,767 loan payment.
At that point, he realizes that his plan is quite risky. Most especially because investments don’t have guaranteed returns, and there will always be months when the market goes down.
And I agree.
Making it Work
In general, leveraging debt for profit through personal loans is difficult because of the high-interest rates. Investing in paper assets such as the stock market is very risky if you use borrowed money from banks and credit institutions.
However, there are of course other means to borrow money. The most straightforward would be from a family member or even a trusted friend.
I once took a loan from my cousin so I could invest in a corporate bond. It’s a fixed income instrument so the risk on the returns is quite low.
I told her I’d pay a 4% annual interest for 5 years, which is more than what she’s getting from her time deposit. Then I put the money in a 5-year corporate bond with a coupon rate of 5.5% per year.
Just a note: She knew where I was putting the money. And she doesn’t really want to be bothered with doing the paperwork to invest in that bond.
On the other hand, taking out a personal loan can work if you invest it in your own business instead, because, from experience, it’s not hard to turn a 10% profit from a business every month.
In fact, that’s what my friend did instead. He went on and borrowed P50,000 from the bank and used the money to buy and sell sneakers online.
He’s been doing this occasionally for the past year and makes around 15% profit per pair that he sells. Through the personal loan, he made it into a regular source of income and hopefully, a full-time business soon.
Always work the numbers before making any financial decisions.
The only time it makes sense to borrow money for an investment is when:
- The expected return is higher than the cost of the loan. And more importantly, it is possible and achievable as shown in a cashflow simulation.
- The investment risk is relatively low with respect to your knowledge, skills, and experience on that investment. Don’t invest in anything that you don’t understand.
I hope this article answers your questions about borrowing money for investments. I’ve received similar questions from the past, so I know that this is a usual concern.