A common phrase in the investment-sphere is “Don’t risk what you can’t afford to lose”. This implies that you’ll most likely shouldn’t take out a loan to invest with it. But is that really true? In this article, we’ll cover the up- and downsides of investing with a loan – what chances it offers but also why it is often recommended against.
Possibilities of using a personal loan for investments
There are quite a few pros to investing with a loan and using other people’s money to achieve higher returns. Let’s look at some of them in more detail.
Higher return on equity
If you’re taking out a loan to invest, then you can increase the return on your equity. A prominent example where this is done almost always is real estate investing. It works like this: Imagine you have a property with a price of 200,000 EUR where you will get 600 EUR monthly rent if you rent it out. You then have two options:
- Option 1) Pay the price for the house in cash (or transfer, but from your reserves)
- Option 2) Make a down payment and finance the rest through the bank, let’s assume 30% down payment
When picking option 1 you would have yearly returns of 7200 EUR while investing 200,000 EUR, which leads to a return rate of 3.6%.
With option 2, you would have the same yearly returns of 7200 EUR but only invested 60,000 EUR, which brings your return rate up to 12%. Of course, you’ll have to deduct the interest rate from your bank off of this, but you can clearly see the general direction.
Your investment could provide an additional income stream
If the interest rates of your loan are low but on the flip side your investment offers a high return rate, then taking out the loan could lead to you being able to create an additional income stream.
Assuming you can take out a 10-year loan for 20,000 EUR with an effective annual interest rate of 6%. Paying back the loan would cost you 167 EUR every month, and the interest would be an additional 100 EUR monthly, making the total 267 EUR per month.
This is how much monthly income you could generate with your money at different return rates:
- At 6% you would receive 100 EUR, so a negative cash flow of 167 EUR per month
- At 8% = 133 EUR, a negative cash flow of 134 EUR per month
- At 10% = 167 EUR, a negative cash flow of 100 EUR per month
- At 12% = 200 EUR, a negative cash flow of 67 EUR per month
- At 15% = 250 EUR, a negative cash flow of 33 EUR per month
- At 16% = 267 EUR, so you would have a net cash flow of 0 EUR
- At 20% = 300 EUR, a positive cash flow of 33 EUR per month
You can see that you would need annual returns of 16% to not pay money out of your pocket. And 16% is already very high. Keep in mind, though, that year by year the interest payments will get lower and that you also build equity.
So, generating cash flow by investing with a loan mainly depends on three factors:
- The interest rate of your loan
- The due date of the loan
- The interest rate of your investment
Risks of using a personal loan for investments
Just as there are benefits to investing with borrowed money, it also has some negative sides. Truth be told, investing by taking up a loan is not for the faint of heart, as it could result in you losing what you can’t afford to lose.
Your interest rates may rise
Often, loans come with a fixed interest rate for a specific time. But what happens, if that time period ends and the interest rates increase drastically?
This is what can be seen in Sweden in early 2023. There it’s common to not have the interest rates fixed for a long term and during the period where the key interest rates of the European Central Bank were 0%, this was no problem.
But now that the key interest rates were raised, so were the interest rates for the loans, leaving many homeowners with dramatically higher mortgage payments.
This does not only influence profitability (of rental properties, for example) but in the worst case, could even mean needing to sell the house you live in, as you’re unable to pay the monthly rates.
One thing you can look out for in regard to interest rates is the Euribor, the Euro InterBank Offered Rate. This index shows you at what rate European banks lend money to one another.
Taking up a loan that is tied to Euribor can work out well, if you’re in a low-interest environment. But if the interest rates go up, so does your loan payment, which creates long-term uncertainty about the total costs.
The investment could decline
Another scenario is that your investment declines, resulting in lower returns. One way this could happen is if you invested into CoCo-Bonds that paid a good coupon rate, but are then scrapped to zero to better the balance sheet of the issuer.
This just happened recently when UBS took over the business of the Swiss bank Credit Suisse and AT1 Bonds (additional tier 1) worth 17 billion USD were declared worthless.
While this is a rare scenario, you should always keep in mind that every investment carries the risk of you losing what you invested in. And if the money you invested is not yours, then you’re in double trouble.
Taking out a loan to invest can make sense in some regards and is even needed in a few areas (say real estate or big businesses). For the majority of people, however, sticking to their income to invest is a far better choice.
The benefit of not needing to worry about crippling debt every night far outweighs the potential reward for most. And you can still earn 14% and up by investing your money.