The road to long-term wealth can be a long one, and when you think about it, many of us take some pretty extreme steps to reach our financial goals. Saving up enough cash for retirement often means investing a percentage of your income for several decades, for example. Some of us start businesses with long odds for success, betting on our own skills and ideas. Others take a slightly different road to financial freedom, throwing money into real estate, for example, or betting the farm on alternative investments.
Regardless, investing for the long haul is usually your best bet to get ahead financially. If you fail to invest and just stick your money under your mattress, your nest egg will be eaten away by inflation with each passing year.
So investing is generally a wise financial move. But should you ever borrow money to invest? Now, that’s an entirely different question. And all signs point to “no” – with a few caveats.
In a real-world sense, we’ve been borrowing money to invest since mortgages were invented in the 1930s. Real estate is one investment where it has almost always made sense to borrow capital instead of paying cash, says Minneapolis Financial Planner Morgan Ranstrom.
When you borrow money to purchase a home, the property can be used as collateral for the bank and, historically, real estate prices have increased over time. Ideally, your home will increase in value while you live there, providing some return when you sell. And, along the way, your primary residence also provides a real need – a roof over your head.
Borrowing money to invest in rental property has also been a smart idea historically. When you become a landlord, you come up with a down payment and pledge to pay for repairs and upkeep while letting your renters pay your mortgage and help you turn a profit. Eventually, you sell the property and realize a net gain – even after accounting for the costs of borrowing (including mortgage interest, taxes, and insurance) and years of upkeep and repairs.
When Borrowing Money to Invest Makes Sense
The concept behind borrowing to invest isn’t rocket science. By borrowing money at a lower interest rate to invest with greater returns, you can realize a net gain and turn a profit along the way.
In the rental real estate example above, let’s say you borrowed $200,000 at 6% for 30 years to become a landlord. Over your decades as a landlord, your renters cover the mortgage and you turn a profit big enough to cover maintenance and repairs – even after paying taxes and all other expenses.
After 30 years, you own the property free and clear and can sell it — likely for a lot more than you paid three decades earlier. In this scenario, you’ll have borrowed money in a way that helped you build long-term wealth, which is a smart idea indeed.
However, there’s still risk involved: If you’re unable to find renters for a stretch, you’re on the hook for the mortgage payments in the meantime. And if the real estate market craters when you need to sell – remember, home prices tanked upwards of 30% in some areas during the housing crisis – you may have to wait it out longer if you can, or cash in a less-lucrative investment if you can’t.
Meanwhile, the “returns” you’ll earn on paying down debt — as opposed to taking on more of it — are guaranteed. If you pay off a large credit card balance that’s costing you 15% APR, you’re essentially earning a 15% return on that money. That’s one reason we typically recommend paying off high-interest debts before you start investing.
Then there are the not-so-obvious ways we borrow to invest. Imagine you have a new car loan at a low rate of 1.9% APR. Instead of paying off your car loan as quickly as you can, you use any extra funds to max out your retirement account because you believe you can receive a greater return by investing in a diversified portfolio of stocks and bonds. And you’re probably right.
Of course, there may be other situations where borrowing to invest makes sense. Indiana financial advisor Tom Diem points out that, sometimes, corporate executives will exercise their stock options or short-term borrowing to fund a business opportunity. Individuals and families also borrow money all the time to fund their business ventures, usually with the intention of building equity and receiving a sizable return on their efforts later on. And obviously, there are other instances where using leverage to invest can absolutely make sense, although they depend on the person and their situation.
Think Before You Borrow to Invest
Unfortunately, borrowing money to invest doesn’t always end well, and there are situations where people do it out of mania instead of rational thought. In December, CNBC reported that investors were actually taking out mortgages and home equity lines of credit to buy bitcoin, the digital cryptocurrency. Also, the search term “buy bitcoin with a credit card” trended so hard it sparked bubble fears around the same time.
In December, Vice Magazine even ran a piece called “Do Not Go Into Debt to Buy Bitcoin, You Idiots,” in which they interviewed Angela Walch, a Texas law professor who studies cryptocurrency and financial stability. Speaking of the news that people were using mortgages to buy bitcoin, here’s what Walch had to say:
“I saw that headline, and that really frightened me, because taking out debt to invest is how people end up getting into trouble. That was at the heart, in many ways, of the financial crisis. People thought their investments could only go up, and when they went down, they couldn’t pay back the debt. If enough people do that and can’t pay back their debt that they borrowed to buy bitcoin, the lenders can eventually be affected by that, and it can just spiral through the system.”
And, look where we are now. While the price of a bitcoin peaked at over $19,000 in December, it’s taken a big hit since and sits at just over $9,000 as of this writing. Of course it may rise again, but that’s nearly $10,000 in losses per bitcoin if someone bought at the top and was forced to sell today.
Kansas City Financial Advisor says the entire situation reminds him of the housing collapse of 2007-2008, when so many people had borrowed way too much on either their primary mortgage or an investment property. These people got caught in a bubble only to face foreclosure or spend years underwater on their mortgages after the real estate market tanked.
“Many had no choice but to walk away facing bankruptcy and damaging their credit for years,” says Haynes. “Borrowing to invest in a stock or bitcoin is no different. If that investment goes south, you better have more money to settle up or face the consequences.”
And perhaps that’s the biggest reason to steer clear of borrowing to invest. Sure, it can make sense if you realize a return that justifies the cost of borrowing and then some. But investing gains are never guaranteed. What if your investment loses money?
Obviously, you’ll still owe the money you borrowed no matter how your investment pans out. Imagine a poor soul who refinanced his mortgage and took out an extra $100,000 to buy bitcoin in December, only to watch its value plummet in half. Even if his bitcoin investment is now worth only $50,000, he’s still on the hook for the full $100,000 (plus closing costs and interest) — and he could even lose his house if he can’t cover the higher mortgage payments.
And potential losses aside, let’s not forget about taxes. Let’s say you borrow money to invest in what’s supposed to be a hot stock, and realize a modest gain. Many types of investments, including those in a brokerage account, require you to pay income taxes on your gains — which could eat into or even wipe out your slim profit margin between the costs of borrowing and your investment returns. Of course, this all depends on your investment returns, the costs of borrowing, and your unique tax situation.
The Bottom Line
It’s tough to imagine a circumstance when individual investors should borrow money to invest, says Ryan Inman, a fee-only financial planner for physicians and host of the Financial Residency podcast. However, leveraging to invest in tangible goods such as rental real estate may make sense if the deal is properly vetted and the numbers add up.
“If you were to purchase a rental property, the cash flow from the rental can cover the debt service (principal and interest payments) and should still have additional cash left over,” says Inman. “While it could be volatile, as we experienced in the financial crash of 2008, real estate is significantly less volatile than picking individual stocks or investments like bitcoin.”
Before you borrow money to invest in bitcoin or the “next big thing,” take the time to run the numbers and think long and hard about the risk you’re taking, says Jon Luskin, a fee-only financial planner in San Diego. When you do, you’ll probably find that the risk of borrowing to invest is just too great.
Finally, don’t borrow to invest just to follow the crowd. Just because other people are doing something doesn’t mean it’s a good idea.
“Terrible investing strategies are usually implemented when someone has absolutely no idea what they are doing,” says Luskin. “And they have no idea what they’re doing because they simply have never sat down to take the time to do sufficient research on the subject.”
Holly Johnson is an award-winning personal finance writer and the author of Zero Down Your Debt. Johnson shares her obsession with frugality, budgeting, and travel at ClubThrifty.com.
Related Articles:
- Eight Reasons to Ignore the Bitcoin Craze
- 10 Things You Need to Do Before You Start Investing
- Eight Questions to Ask Yourself Before Investing in Anything
The post Please, Don’t Borrow Money to Invest in Bitcoin (or Anything Else) appeared first on The Simple Dollar.
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