As I go out on a limb and write posts about the evils of consumer debt and borrowing to invest, I get comments on these posts that provoke a lot of thought. Like this one excerpted from Enough Wealth's comment regarding my aversion to debt:
[Borrowing against existing net worth to invest in additional assets] requires getting educated about reasonable risk and return
estimates for the various asset classes, understanding of your own risk
tolerance, planning to control the amount of risk you actually take on.
Being frugal, paying off debt, saving and paying cash is better than
living off credit. But you have to take on some investment risk if your
savings are to earn more than the risk free rate (which is usually
around the inflation rate).
If you are truly “risk averse†than you won’t get past [living debt-free], and
your net worth will only ever be a multiple of whatever part of your
earned income you can save …
These are good points. Spending less than comes in and investing the difference for many years will do a lot of good in retirement IF the investments perform well. If they don't perform well, you're in trouble.
This is where the risk comes in. All investments have risk. Guaranteed returns on investments are low-risk, but only insofar as the entity providing the returns is solvent and doesn't change the rules mid-stream. Also, it's only as low-risk as the valuation of the currency will allow; inflation needs to be considered.
Higher-risk investments (junk bonds, person-to-person lending, stocks, for example) have the potential for higher return. They also have the potential to lose their value a lot more. The companies issuing junk bonds go into default more often than AAA-rated companies. Borrowers on Prosper.com occasionally skip town. Stocks tank. Due diligence can provide a more accurate assessment of the risk involved, and therefore the amount to invest and the rate of return to demand.
When you borrow to invest in something (use leverage), you can take a larger position in the investment (loan more money, buy more real estate, purchase stocks on margin, etc.) than you could if you had put up cash. But the return on the investment needs to beat the rate that you invested at, after taking out fees, taxes, inflation, etc. So, even more research and education is needed for borrowing to invest.
This is why I suggest using leverage with enormous care. I was never dead-set against using leverage to invest in something, but it's really necessary to do a very careful assessment of what you're getting into if you're borrowing to invest. (Maybe I shun it because I don't trust myself enough yet 😉 ) If you intend to pay cash for an asset, the main question to ask is: “Can I recover if I lose my investment?” But if you borrow to invest, the question is a little more imposing: “Can I recover if I need to repay the loan out of pocket?” Losing $5,000 that you had set aside for investing is one thing. Losing $25,000 on an investment that you borrowed $100,000 for using a $5,000 down payment could be another matter entirely. Leverage is great when you can use other people's money to make money for you. It's horrible when you're not keeping up with the payments.
Some thoughts on when it might be prudent to borrow to invest (of course, seek professional financial advice elsewhere for your own situation):
- When you know what you're doing. I mean really know what you're doing. You know the market, you know the risks, and you above all understand what you're investing in. You can spot the deals — the houses that are priced way below what they're worth, the people with poor credit ratings that are actually low risk borrowers, and the temporary discounting of otherwise great stocks.
- When you can borrow at a competitive rate. The folks who are borrowing to invest on Prosper.com almost always have A-rated or AA-rated credit. This lets them borrow at about 8%. They intend to lend at higher rates to those with poorer credit, but the margin of safety is greater than if they had only been able to borrow at 11% or 12%. You reduce risk at the lower borrowing rate because there's more room for error. You don't have to take on as much risk to get a positive net return.
- When you can afford the worst case. Borrowing $5,000 on Prosper when your liquid net worth is $1,000,000 is low-risk. The debt is easily covered if something goes terribly wrong. In this situation, the borrower can easily get out without much problem except a bruised ego.
