Borrow to invest?

Read first our article Invest or pay off debt?

investing 787x475 cLet us consider the reverse scenario to paying off all your debts – should you borrow to invest?
Maybe!

Among other things, you should consider these factors:
Where can you get the most profit? (math)
- The interest rate of the loan?
- Do you need to make regular amortization payments?
- The interest rate of the investment?
- Management fees?
- Inflation rate?
What is most important to you? (psychology)
- Is it a secure investment or are you risking your money?
- Are you willing to live with the potential psychological pressure that you, for instance has borrowed against your living, to invest in something else?
- How long is the investment secured or locked for access?
- Do you get a dividend?
- Do you reinvest the dividend, creating compounding investment?
- What kind of investment is it?

What are you investing your loans in?

Note
Every investment has certain risks!

Different investments have different risks and rewards. It is always up to you to consider the risks and rewards of an investment. And it always come down to the two questions above, which is about math and psychology. It all comes down to what you are willing to risk, in relation to what you are able to win.
Normally, a general rule of thumb is not to invest any money that you cannot afford to lose. However, investing for your future financial freedom and retirement, we would say that there are good investments that you could borrow to.


Explaination - Inflation

Inflation is the degree (percentage) in which your money decrease in value each year. Most governments want this to be around 2-2,5% each year, to stimulate consumption and business growth.
This means that if we have an inflation of 2% per year, £102 next year has the same real value as £100 this year.

Explaination - Property equity

Property equity is the amount of money you have in a property which you do not have mortgaged. Assume you have a property with a market value of £100.000. You have a mortgage of £60.000. Then your equity in the property is £40.000, which is the difference between the market value and the mortgage.


Examples – investing borrowed money

Consider these examples, which are examples of possible, and even common, ways of investing.


Example 1 – Investing in stocks

Instead of paying off your mortgage, you borrow more money against the equity on your house, to invest in stocks.

The advantage of stocks is, that invested in the right company on the right market, you can gain a good profit. However, stocks is considered one of the more volatile investments, meaning that even if the stocks normally increase in value over time, there can be longer periods of time that the stocks decrease in value. If you sell your stocks during this time, you will lose money instead of gaining money. You are never certain of the outcome of the investment.

Lets assume that the mortgage on your house is 3%. You estimate an investment in stocks to give you 30% profit over one year. In short – that should mean that you gain a 27% profit during one year – in theory!
Lets assume that the stocks you buy increase in value by 47% during the first 9 months. After that they decrease in value over the next 3 months, giving you a total loss of 8% at the end of one year.
But if you stick it out and let the investment run, at the end of year 10, we assume your stocks has increased in value to a total of 179%. Meanwhile your mortgage costs is 34,3%. (Compound interest of the borrowed money over 10 years, inflation not included).
Is this an investment that you would do?

Lets assume that the stock has decreased in value to -37% over 10 years. Besides the loss in the stocks, you have also the mortgage costs of 34,3%.
Is this still an investment you would or would not do?

Note:
Investing in stocks takes knowledge, skills, time and money.
Research show that investing over one year period may increase and decrease investment value, however, investing over any 10 year period has always resulted in an increase of investment value.
(The exeption is the crash of 1929, which resultd in that the 10 year period of 1929-1939, stock investments decreased in value, but only almost -5%.)



Example 2 – Investing in property

Instead of paying off you mortgage, or putting money into government pension schemes, you invest the money in a second property. You are using your savings or the equity in your property (your home) to invest in an asset, which gives a monthly return, and perhaps even a capital gain when you sell the property.

Property and real estate is normally a much more stable investment, where the value of a property normally increases over time. However, a warning should be emphasized: the value of property has known to crash now and then. But it always come back up again, even if it takes years. You stand the risk, and you profit from the value increase.

Lets assume that you borrow £50.000 against the equity of your home, at 3% mortgage interest. You buy a second property, which you rent out. You receive monthly cash flow of £450 per calendar month (pcm).
You have expenses on the property of £250 pcm. Your increase mortgage will cost you 3% of £50.000 per year, equal to £1.500 per year in interest, and £125 pcm.
Monthly Income £450
Monthly Expenses -£250
Monthly interest -£125
Monthly cash flow £75

Owning and managing a second property, you have now become a self-employed business owner.
Is this something you would do?

What if the expenses of the second property was £125 pcm, the monthly rent was £470 pcm and the interest was 2%, equal to £83 pcm, resulting in a cash flow of £262 pcm, or 6,3% profit per annum.
Is this still something you would or would not do?

Even if this is a simple example with a low profit, using an interest only mortgage, and giving a very small monthly cash flow, we are showing the principle of borrowing to invest  This is a solution not uncommon to the property investment market.



Example 3 – Investing to fixed interest

Instead of paying off your mortgage or investing in your government pension scheme, you invest your money in a company that give you a fixed interest, higher than the current bank rate.

Lets assume that you borrow £50.000 against the equity of your home, at 3% mortgage interest. You lend out your money to an investment company that use your money for an investment (just like any bank). As a thank you, you get a fixed interest of 8%.
That means that you have a profit of 5% on the £50.000. And you don’t have to do anything to profit from your money. The company stands all the risk, and you are rewarded for lending your money. You are now an investor!

Is this something you would do?

Lets assume you borrow £50.000 against the equity of your home, at 3% mortgage interest.  And you get a fixed interest of 10%.  You now gain a profit of 7% on the £50.000, without doing anything.

Is this still something you would or would not do?


 


Example 4 – Investing in mutual funds

investment balance 10000 initial investment

Instead of paying off your mortgage, you place your money into managed mutual funds.
The advantage with mutual funds is that, over time you can gain a good profit. Since mutual funds is a portfolio combined of several stocks in different companies in different kinds of businesses, mutual funds are not as volatile as stocks.

The main disadvantage is that the funds always has a management fee. This is usually, only 0,65 – 1,3%, which seems small. But over time this management fee can reduce your potential profit considerably.
Lets assume you invest £10.000 in mutual funds, giving a profit in average of 10% per year (which is higher than normal average), and you let the profit run, i.e. reinvesting the dividend back into the mutual fund.
You have doubled your money after a little more than 7 years. After 30 years, you will have £174.494 worth of mutual funds.

Now, lets assume that you have a management fee of 0,99% and lets see the difference.
Now it will take more than 8 years to double your money and after 30 years you will have £129.465 worth of mutual funds.
In short – a small management fee of under 1% will result in reducing the profit £45.029 or 25,8%.

[This pictures show the compounding effect. Even though you invest a one time investment, your investment grows exponentially to enourmous amounts.]

investment balance AllCosts 10000 initial investment

Is this something you would do?

With an investment period of 50 years, the result is this:
Resulting capital in the mutual funds is £1.173.908, with an increase of 11.639%, if no management fee is applied. If a management fee of 0,99% is applied the resulting capital is £720.955 and an increase of 7.038%. The management fee result in a decrease of £460.090 or 39,2%.
Is this still something you would or would not do?

 [This picture shows the effect of the management fee, even a small management fee.  The lower, red line is the investment growth when you have a 0.99% management fee, and the blue line is the growth without any management fees.]

Note
The cost of the management fee increase in proportion to the length of the investment, due to the compounding effect.  Over a 40-50 year period, it is not unusual to loose 40-50% of your investment to management fees.


Additional reading

Continue by reading this article on how you could use loans to invest to build your future  Read More

Read our articles about bulding your retirement pension funds by investing smart Read More 

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