With record low interest rates and stocks trading far below their true value, more and more people are considering borrowing money to invest (also known as “leveraging”) to help boost their lagging retirement portfolios. While leveraging is a viable strategy in some cases, it carries many risks that must be fully understood.
How does it work? An investor would borrow a sum of money and then turn around and invest it. The theory is that you would be able to earn more in returns each year than you’ll pay in interest. The interest you pay is also 100% tax-deductible which helps this strategy produce even more favorable results. Example – You borrow $25,000 and pay 3.5% interest. Interest costs total $875 per year (which you can write off). You earn an average of 6%/yr on the investments you select which provides $1,500/yr of earnings. Net result is $625 of growth after interest is paid plus an $875 tax write-off.
Sounds too good to be true? Not necessarily but there is plenty that can go wrong. The biggest risk is a lack of investment performance. If you earn less than 3.5% or even go down in value, the shortfall must come from your pocket. Imagine borrowing the same $25,000 and after 3 years the account’s value is down to $22,000 and you’ve had to pay $2,625 in interest charges. You’re out of pocket $5,625!
So who is this right for and when’s the right time? Everyone’s situation is different but here’s a list of characteristics that serve as a guide:
- Your risk tolerance will allow you to watch the ups and downs of the stock market without panicking too easily and wanting to back out.
- You want to stick with quality investment choices in your leveraged investment plan – not looking for the next big penny stock.
- The stock market is in the midst of a downturn (like now) and interest rates are low.
- You have a high net worth and can afford to lose a portion of your investment.
- You have at least 10 years or more until retirement.
- Your plan is created to borrow only a portion of what you can “handle”. If you qualify for a $100,000 investment loan, plan to start with $40,000-50,000 at most.
How do you set this up? There are many factors to consider when partaking in a leveraging strategy. Can the loan be subject to a margin call? Is the interest rate fixed or variable? How secure are the investments? What happens if the account loses money?
There is a group of investment advisors and companies out there that look at borrowing to invest as the right solution for everyone who walks through their door. They see this as an easy way to boost their assets under management (and therefore their fees). If anyone suggest this strategy to you right off the bat without getting to know your full financial situation, you should look for a second opinion. Any good advisor will tell you that leveraging accounts for 5% of their business OR LESS.
As appealing as any investment strategy may sounds, make sure you take the time to properly research the plan you’re putting in place. Leveraging is a tool that magnifies the emotional side of investing and consumers often discover that they don’t have the stomach or the cash flow to support this strategy.
Borrowing to invest is not suitable for everyone. You should be fully aware of the risks and benefits associated with using borrowed money to invest since losses as well as gains may be magnified.