A few years ago, my wife and I had the opportunity to invest in a company that we hoped would go public. We were young, just married, and broke. So we took out a personal loan from a family member (for a fairly small amount) to make the investment.
Within months, the company went belly up. Since we weren’t able to recoup a single penny from our investment, we were left to work off the debt. This experience taught us several valuable lessons. Among those lessons was that one should be extremely cautious when using leverage to make an investment or increase the expected return on an investment.
Let me give you four reasons not to use debt to invest
First, you may not have the right experience to manage the use of debt, such as borrowing from a margin account, when investing. Without the aid of an experienced advisor, avoid using financial instruments such as margin accounts.
Second, for the average Joe, slow and steady will win the race. We all have goals and dreams and it would be wonderful to achieve them today. However, our dreams can become nightmares if we try to run to them too quickly. Realize that if you follow tried and true investing techniques, you will arrive at your goals and have had peace of mind along the way.
Third, your mama was right – don’t spend money you don’t have. This is the foundation for any solid financial house. I read an article several months ago that referred to credit card arbitrage, which is borrowing money from a credit card with a very low promotional rate and then investing the borrowed money. The idea is that you’ll pay off the credit card before the interest charges hit and you’ll have made more money from investing the money than any fees associated with borrowing the money (e.g. cash advance charge).
The problem is that you are building a house of cards. What if you can’t liquidate the investment in time to pay off the credit card? Even though the nice marketing pitch says you pay no interest, it is actually accruing. So if you don’t pay off the credit card within the promotional period, then wham! You’ll be hit with all of the interest charges.
Fourth, we become too emotionally involved. For many people, investment decisions are based on emotions. We see the market begin to fall or rise and we sell or buy accordingly. So if we know that getting out of a bad investment now means we are left owing the debt, then we may choose to not sell hoping that the investment will come back. We may get lucky and the investment rebounds, or the investment will decrease in value even further leaving us with even more debt to repay.
So why would anyone use debt or leverage when investing?
Leverage acts as an accelerant. Just like adding gasoline to a fire, leverage can allow you to gain larger returns than you would otherwise be able to obtain.
Also, leverage increases the percentage return on an investment. Ever heard of OPM? Other People’s Money. Here’s a specific example.
- Scenario 1: I invest $100,000 and gain a return of $10,000. My percentage return is 10%.
- Scenario 2: I invest $10,000 of my own money and $90,000 of borrowed money (or OPM). If the return is still $10,000, then my percentage return is %100. This of course assumes no fees or interest associated with borrowing the $90,000, which is never the case.
Scenario 2 sounds nice because my return is %100 and I only had to tie up $10,000 of my own money. Though, at the end of the day, I’m $10,000 richer in either scenario. And I’m not financially committed to someone else in Scenario 1 if the investment begins to sour.
What are your experiences with using debt to invest? Good or bad. Also, sign-up for our RSS Feed for timely updates on other financial topics.