Should You Use a Personal Loan for Investing?
You may have heard the adage, “It takes money to make money.” Seldom does that feel more true than with investing. Saving money to invest takes time, though. While it may be tempting to skip ahead by taking out a personal loan to invest, this strategy comes with multiple risks that may not be worth the potential reward.
Can a personal loan be used for an investment?
When you take out a personal loan, you’re given a lump sum of money that you then need to repay plus interest over a predetermined amount of time. You can get a personal loan for anywhere between $1,000 and $100,000 or more, and often with terms between 12 to 60 months.
A major appeal of personal loans is that they can be used for almost any purpose — even potentially investing. However, some lenders expressly prohibit borrowers from using funds to invest. For example, online lenders Upgrade and SoFi both prohibit using a personal loan to invest. If lenders don’t allow it, that should be a red flag about the risks involved.
Before applying for a personal loan, make sure you shop around to ensure your lender allows you to use the funds for your purpose. You’ll also want to make sure you’re getting the best rate and terms since the costs of the loan will erode your overall returns.
You should also ask yourself key questions when applying for a personal loan, such as how much you can afford to borrow and what will happen if you default, to determine if it’s the right fit for your needs.
Risks of taking out a personal loan to invest
While everyone’s financial situation is different, there are general risks that always apply when using a personal loan to invest. This is because you’re on a hook for personal loan payments regardless of how your investment performs. A negative return on your investment, or even just the amount of taxes you’ll owe if you sell at a profit, could put you underwater on your loan.
Here are a few reasons why taking out a personal loan to invest may not be a good idea:
- The investment may crash: There are no guarantees in investing. If your investment goes south, you could lose all of your money and still need to pay off your loan. When borrowing money to invest, you stand to lose even more than you put into the investment because you have to pay back the interest on the loan.
- You may owe more in loan interest, fees, and taxes on your loan than you earn on the investment: Even if your investment appreciates, it may not be enough to compensate for the interest rate, fees and taxes you’ll owe. Personal loan interest rates generally range from 6% to 36% and they may also contain extra charges, such as an origination fee. While personal loans generally aren’t taxable, your investment gains will be, so this, too, can eat into your earnings.
- Missing loan payments can hurt your credit: When borrowing to invest, you’re gambling that the investment will return enough money in time for you to repay your loan. If this doesn’t happen and you can’t pay your lender on time, your credit score may take a hit. Missing even one monthly payment can hurt your credit score because payment history accounts for 35% of your FICO Score.
- You’ll have more debt: Regardless of how your investment does or how quickly you pay off your personal loan, you’ll still have taken on more debt than you started with, which can hurt your debt-to-income (DTI) ratio, and thus your credit score. Even just applying for a personal loan can hurt your credit score since the lender needs to do a hard credit inquiry to determine if you qualify.
When taking out a personal loan to invest could make sense
Despite the risks of using a personal loan to invest, there are some limited instances where borrowing money to invest could work. The key here is that for this strategy to be profitable, the return you get on your investment needs to be higher than the costs of your loan so that you can repay the loan and still have money left in your pocket.
You have the best chances of achieving this under the following circumstances:
- You have excellent credit and qualify for a low APR: The biggest cost to a personal loan is the annual percentage rate (APR). The lower the APR on the loan, the less of a hurdle you’ll have to overcome to earn a profit on your investment.
- Your investment has a fixed return: The most reliable investments are those that offer a fixed rate of return, such as I-bonds and certificates of deposit (CDs). If the interest rate on your fixed investment is higher than the APR on the personal loan, you could make money by using a loan to invest.
Ultimately, taking out a personal loan to invest is a, well, personal decision. You have to be comfortable with the risks and confident in your chosen investment’s return potential for this strategy to work out. If you’re considering borrowing money to invest, make sure you do enough research to determine what loan, if any, is best for you.