The Pros and Cons of Borrowing To Invest

Investors who do not have a great deal of available cash often borrow money to make investments. This strategy is called leverage, and can actually help to increase your returns under the right circumstances. It is important to understand, however, that while leverage can help to boost returns, it can also magnify losses.

Borrowing to invest through a stockbroker is called buying on margin. Typically, you are allowed to borrow up to fifty percent of your investment on margin. However, you must maintain that 50 percent level. Therefore, if markets go down you may have to put more money into the account to cover a "margin call". Another popular means of leveraging is using a line of credit or personal loan to invest. In this case, you have to be very sensitive to the fact that you are putting the collateral behind the line of credit or loan (possibly your house) at risk if the value of your investment decreases substantially.

Here's an example of how leverage can magnify your returns in times when markets are increasing:

You have $1000 to invest. You borrow an additional $1000, so you have $2,000 to invest. You invest the entire $2000 in 200 shares of ABC Co. at $10 per share. Three days later, the market value of ABC Co. surges to $12 per share, leaving you with a hefty profit of $400, less interest costs. That's almost a forty percent rate of return on your original $1000 investment, compared to the twenty percent rate of return that you would have achieved had you invested without borrowing.

This amplified rate of return is the reason many investors are attracted to the practice of leveraged investing. Investing on margin when markets are going down, however, can also increase your losses.

Consider the previous example, except that the market value of ABC Co. now decreases to $8 per share. If you were to cash out your investment, the rate of return would be minus forty percent. Compare this to the twenty percent loss that you would have sustained had you strictly invested your own money. In addition, if you were borrowing on margin, you would now be faced with a margin call, or request by your broker to add money to your account to make up the shortfall in your account.

Investing with borrowed money can be a very effective method of improving your investment returns, as long as your investment goals and objectives are being met. If your risk tolerance level is high enough to include leveraged investments, you might want to review the following tips before investing on a loan:

• Borrow only an amount you can afford to pay back
• Keep a financial cushion to see you through declines in the market
• Keep an eye on interest rates and inflation - increased rates can cut into your returns
• Know the consequences of using collateral as security for you loan
• Understand the tax consequences of margin profits
• Make sure the investment meets your objectives and risk tolerance levels