Should You Borrow To Invest?

After a long bout of pessimism and air of resignation, now markets ride high on wave of hope—that of revival. This hope rests on the expression ‘worse is over’ and it provides a strong source of energy to be one of the earliest to grab opportunities in the markets. Quite palpably, today, as 'risk on trade' catches up and indices rise, it is time for 'greed' overpowering 'fear'. It is also the time when the upside looks attractive than the possibility of loss of capital. So, should you borrow to invest in markets?

One of the most sought-after options is approaching a bank. Banks do not offer loans for speculative purposes as the thin line between speculation and investment is very blurry in several cases. So, no bank would ever want to lend if your purpose of borrowing is 'investing'.

However, with some know how you can still raise money from banks. Some smart lads go for personal loans, some raise funds by taking loan against property route. Some approach friends and relatives for money.

Many propose the thought of borrowing money to invest by presenting successful stories of traders who made a fortune after borrowing money. You may choose to argue that one can make 20% on one’s investments each year, why not borrow at 14% and pocket the difference of six percentage points. For example, if you borrow, Rs 1 lakh at 14%, you end up repaying Rs 1.14 lakh. If you make 20% on investments, you take home Rs 6 thousand out of Rs 1.2 lakh- the value of his investments at the end of the year. This logic is quite acceptable but doesn’t work always.

Let us look at various aspects:

What happens when an individual borrows money to invest or to speculate? It all starts from the act of borrowing. If you decide to go for a personal loan, your rate of interest is anywhere between 16% and 24%. Some still want to go for it saying I can borrow at 16% and can think of making 20%.

Let us see how it turns out. Returns on your investment (say 20%) may come across the year or at the end of year or at the beginning of the year. But your loan must be paid in equated monthly instalments (EMI). For example, if you take a home loan for one year of an amount of Rs 100,000 your EMI stands at Rs 9,073 at 16%. How are you going to fund this EMI? If you do not have enough cash flow in place to pay off your loan, you may have to keep selling your 'investments' and your returns expectations may not materialise ever. Cash flow mismatch is just one angle of the issue.

Interest rate on your loan is a bigger problem. It decides your hurdle rate. If you are investing your own funds, you may settle for a lower return in a bad year and still be happy. But if you are borrowing money, you have to earn at least equal to the rate of interest on your loan. In such a situation, you may end up taking undue risks.

Another problem: what if you make losses? Your lenders don't let you go. You will have to pay back the interest and capital they have lent you in advance. In that case, you are paying out of your own pocket. Typically an asset backed loan – loan against property – reduces the rate of interest on the loan. Also the amount lent too is high compared to a personal loan. In many cases, traders opt to raise money offering their house as security. If a trader who opted for a large sum mortgaging his house incurs losses, the lenders simply sell off the house. The trader may lose his house; forget making money on his bets.

While there are some success stories of individuals making it to sky with borrowed seed capital, there are many more untold stories of invited troubles as individual speculated using borrowed funds. It may work for the handful individuals who understand the risk associated with volatile and unpredictable world of investments. Rest should patiently build their fortunes with their own money brick by brick.

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Rajiv Raj is the director and co-founder of www.creditvidya.com