Should you Borrow Money to Invest?

BORROWING TO BUY SHARES.

You know that stocks have returned an average of 17 to 18%. So you borrow some money at 9% interest and invest that amount in stocks. Until you realize the profit, you’ll pay interest or EMI from your pocket.Anyway you look at it, it’s going to be profitable. How about that? If you are planning to do something like that – you’re at the right time reading this article. Calculations on paper may show that it is practical. But in real life, such strategies are extremely risky. We advice not to leverage (that’s the financial term for using borrowed funds) your investments in any form. It’ not a good idea at all. There are three perils waiting for you when you leverage –

  • It multiplies your risk.
  • Even when the value of your holdings go down, you have to pay your loan installments. The effective cost you pay is very high.
  • There will not be any peace of mind. Guaranteed!

HOW DO INVESTORS LEVERAGE?

There are different ways:-

  • Take a personal loan or pledge you home or property or gold.
  • Borrowed funds from others like friends. The attraction here is that, it normally comes interest free.
  • Using borrowing facilities at the brokerage firm.
  • Short sell the stock. It is same as selling what you don’t have. Hence effectively, you are borrowing shares from someone and selling it.
  • Take the derivatives route ( futures and options)

The first two options need not be explained .It’s straight, simple and needless to say, totally dangerous. In the first case, If you could not pay back the money, your lose your home. In the second case, you’ll lose your friends and may also have a difficult time facing them. It might also put your friends in trouble. So stay away from such tactics.

The other three points need some explanation. Brokerage firms allow you to borrow money from their account based on the current total holding you have in your demat account maintained with them. What they do is very simple. They will take pledge of all your share holdings and give you a loan which would be a percentage calculated on the market value of the holdings. In case you couldn’t pay back the money to the broker, they will immediately sell off those shares in the market and realise the amount. At the time of signing the agreement itself, such clauses are already built into the agreement. The interest charged for this kind of temporary funds is also very high and it’s calculated on a day to day basis.

You can adopt this way of leverage when you do it for a very temporary purpose. For example – you were eyeing a particular stock and that stock is now at the price where you want to enter. You have money in your bank, but you’re travelling and not in a position to transfer it now. You can use money from your broker and pay it back in two days.

Another way to leverage is short selling. When you short sell a stock, you are selling stocks which you do not own. What you are effectively doing is, you borrow shares (instead of money) from the brokerage firm and when the price falls, will buy it gain and give it back to the broker. Short selling is a dangerous method to make money. What will you do if your calculations go wrong? You will have to pay more money and buy back the shares from the market and return it to your broker.

Through derivatives, you leverage in a different way. For a small sum (called margin money / premium) you can take big positions in the markets. It’s like playing a Rs 100,000 game with just Rs 10,000 in hand. The risk in such cases is very high. It has the potential to wipe off all your money. Derivatives are the favorites of speculators, although these instruments are basically meant for managing risk.

In short, if you ask us whether you should borrow funds, our suggestion is:

  • No, if you’re just a beginner or amateur.
  • No, if you don’t have any other sources of income to suddenly raise funds if calculations go out of control.
  • No, if you do not have an alternate plan to pay off these debts.
  • Yes, if you can get some funds totally interest free for a long period of time
  • Yes, if you are a very seasoned investor and you know with some certainty how the markets will move.
  • Yes, if you want to utilize a sudden surprise opportunity.
  • Yes, if you have fully understood the risk and the financial destruction it can bring, but still, you’re the daredevil type – ready to face anything.

BORROWING TO BUY OTHER ASSETS.

if you can get loan funds at a lower rate of interest (NRIs can get it , say at 4%) you can bring that funds to India and invest here in debt funds or NCDs that give as high as 13% per annum in return or they buy gold or just put it in fixed deposit with banks. Anyway , that’s not going to be a loss.

One factor that needs to be considered while buying assets with borrowed funds is that the loan to asset value should be preferably be kept at around 60%. That is, to buy an asset worth 10 lakhs, it good to borrow up to 6 lakhs and pay the balance in cash.

And remember, cars and electronic gadgets are not assets hence, relying on loans to buy such things Involves great loss.Such loans carry high rate of interest and these items depreciate heavily with time.

CONCLUSION.

Investing with borrowed funds is not recommended, except in very special circumstances. It is a very risky and aggressive strategy and should be used with a lot of caution.

You may like these posts:

  1. Where can you invest?

2 Responses to “Should you Borrow Money to Invest?”

shubh

November 23, 2012 at 10:37 pm

Is it necessary to have broker for handling the transaction of Demat account (Intra day trading)?
Can’t we do self transaction from home?
why do we need broker?

prashanth

February 4, 2013 at 9:28 pm

wonderful concepts in a laymans language

Leave a Comment