It takes money to make money.
There is a lot of truth to that old adage. The more money you have to invest, the more money you can expect to earn in return. The problem is, what if you don't have much money to get started – does it make sense to borrow to invest?
Using a personal loan to invest is a controversial idea. It can certainly amplify the returns you would get from your own resources, but it also amps up the risk.
On some level, investing with borrowed money is not as unusual as it might seem. Millions of Americans have both investments and loans at the same time. Most of them don't borrow specifically to invest, but instead have car loans, mortgages, or student loans at the same time they are building their IRAs, 401ks, or taxable portfolios. Rather than paying down their loans faster, they are choosing to invest the money instead.
However, using a personal loan to invest takes this idea to another level. Unlike with a car loan, mortgage, or student loan, if you borrow specifically for investment capital, you won't have anything else to show for it. The entire success or failure of the loan depends on how well your investments do. Before you undertake such a risky proposition, it is important that you know all the dynamics involved.
A key factor is how much the personal loan will cost, because this will count against whatever return you earn on your investments. According to Federal Reserve figures, the average interest rate on a personal loan these days is 9.70 percent, and expect to pay even more if you don't have great credit. Historically, stocks have not done much better than that over the long-term, and with current Treasury bond yields below 3 percent and deposit rates under 1 percent, paying 9.7 percent interest is a huge hurdle to overcome before you can start making money.
Besides the interest rate, there will also be closing costs associated with a personal loan, which will reduce the amount you have available to invest right up front. This is the equivalent of starting your investment off with an instant loss.
If you decide to use a personal loan to invest despite these hurdles, at least improve your odds as much as possible by shopping around for the best loan terms available.
Another significant issue with using a personal loan to invest is timing. Personal loans are usually only a few years in duration, at most, while most investment returns are unpredictable – especially for higher-returning asset classes like stocks.
For example, over the past 10 years, U.S. stocks have averaged a total return of just 6.45 percent per year. Personal loan rates have been above 10 percent for most of that decade, meaning that for the most part, this would have been a disastrous time to put borrowed money into the stock market.
Volatile investments can take a very long time to play out, and personal loans just don't give you that kind of time.
Borrowing to invest is known as leverage, which amplifies both the potential returns and the potential risks of an investment.
For example, if you have $1,000 that you have saved up, and lose 10 percent of that in the stock market, you will still have $900. If you borrow $1,000 to invest instead and have the same 10 percent loss, your investments will be worth that same $900 but you will owe repayment of $1,000. This means rather than having $900 when it is all said and done, you will actually owe $100 more than you have left.
Note that the above example does not include the interest you would owe, which further raises the hurdle you have to clear to come out ahead by investing borrowed money.
The costs and risks of borrowing to invest are considerable, but what about the rewards? Here are some potential benefits:
- Returns. Just as using leverage amplifies your risk, it also amplifies your reward if your investments pay off sufficiently. It basically gives you the chance to make money out of nothing, as long as the investment return is enough to clear your interest payments and closing costs.
- Employer matching. An intriguing possibility is using borrowed money to invest in a retirement plan with an employer match. For example, some employers will kick in a matching contribution equal to 50 percent of a designated portion of the money an employee chooses to put into the plan. You couldn't put in borrowed money directly, but you could borrow money for living expenses so you could afford to defer more of your paycheck into the plan to take full advantage of that 50 percent match. That's like getting an instant 50 percent return, which would more than overcome the cost of the loan and would considerably mitigate the investment risk. Keep in mind, though, that you would still have to make regular payments on your loan, and the money in the 401k plan would not be accessible without significant penalties for early withdrawal.
Using a personal loan to invest is not for the faint of heart. Whether or not you think it is worth the risk, you should also carefully assess your ability to make the scheduled loan payments before you commit. Then ask yourself how you would feel about making those payments to pay off an investment that didn't work out. You may well conclude that you'd rather direct those payments into an investment program over time as you can afford them, without amping up the risk by investing borrowed money up front.