The Dynamics of Fronting the Principal Through Loans
The first thing to realize when we are considering taking out a loan to invest is that, like all loans, the loan needs to be paid back on a regular schedule. If one does not have the means to do so, then one certainly should not take out the loan.
Banks will be more willing to loan if securities are to be bought with the proceeds, and therefore they are less concerned with your ability to make the payments out of your present income than they would be if the loan was not secured.
Securing loans with securities is preferable to both the bank and the borrower, due to the liquidity of the assets. In comparison, the only way to use the security of your home or your car to manage paying back a loan is when you default, when the worst has happened.
With stocks though, a portion of your position can be sold if needed, and this is why loans for investments are more flexible. Having said that, it is not a good idea to take on loans you cannot pay back comfortably without needing to sell assets.
This is especially true if you are using the proceeds of the loan to actually invest, over a period of years and usually many years. There are traders who borrow with a view of paying back the loan through their trading profits, although this should be limited to those with proven ability and is of course considerably riskier than trading with your own money.
The only real way to make sense out of taking out loans to invest is if we can manage paying down the loan ourselves, without ever having to touch the investments, and in this case we’re trading off the difference between the expected return of the investments over the life of the loan versus the cost of borrowing.
If, for instance, we expect a 10% increase in our investments, and it will cost us 5% to borrow the money, if this actually happens, we’re going to be better off after the 5 years of the loan than if we didn’t take it out.
As an alternative, we could just take what we were planning on using to pay off the loan and invest that each month, where the cost of borrowing in this case would be zero, and at the end of the 5 years our contributions to our investments would be not just the principal of the loan but that plus the cost of borrowing.
On the other side, since we’ve front loaded the investment with the loan, should the market be in our favor, this will increase our gains. The reverse will be true if the market goes against us, where our losses will be higher than if we invested with cash.
The Biggest Factor Here is the Market
Speaking about the market is almost taboo in today’s investing culture, but regardless of the type of investment or investment strategy, market conditions are not just important, but the most important thing.
If someone was looking to borrow to invest during a bear market for instance, the question we need to be asking is whether they want to increase the amount they will lose, and if so, front loading an investment going the wrong way and likely to continue doing so would be a great idea.
If you are looking to sell investments though, you don’t want your livelihood to be cyclical, where you sell a lot during the so called good times, the bull market phases, and very little during bear market phases.
Therefore it’s better to do your best to dissuade people from even looking at the cyclical nature of markets, and you can just tell yourself and your clients that none of this matters. It’s all about the long term, and what happens over the next 5 years really won’t matter much, not that anyone can ever predict such things.
This is all completely false, as we can predict such things fairly well, and while the time horizon of the investment may be long term, deciding whether to front load it over the term of the loan you’re considering is purely short term.
Comparing taking out the loan or not, in both cases, after the term of the loan is up, we’re fully invested in it with the amount of the loan, with the difference being that with not taking out the loan we just contributed to it over the term gradually.
It does not make any sense to ever look at time periods past the term of the loan, as this is irrelevant, and in both cases we’re invested our money. With the loan, we’ve invested it faster, so the outlook for the investment over the term of the loan is the only thing that will matter, and will matter a great deal.
If you’re doing this with a very good expectation of the price of the assets going up, then taking out loans will make a lot more sense then during times of market neutrality and especially during market pullbacks.
This needs to be the first thing we look at when considering doing this, at least when we’re looking to borrow in any sensible way, where we’re just going to leave these investments alone and not ever cash them out to pay back the loan. We’re making a bet here and the bet is that what we invest in will do well during the life of the loan, and how we do will depend entirely on how right we are, during this time frame and during this time frame only actually.
If we at least understand this, we’ll be prepared to make at least a somewhat informed decision on whether to borrow to invest at a given point in time.
Ways to Borrow to Invest
As is often the case with other forms of borrowing, those who are looking to take out a loan to invest may want to go with an installment loan, where the principal is paid down over a fixed number of years, or a revolving loan, a line of credit in other words.
The rate we get will matter a lot, as this is the benchmark that we’ll have to beat, and need to be expected to beat it by a significant margin in order to make sense out of the borrowing.
The product that is most suited to this type of borrowing overall is a secured line of credit, which offers better rates than loans or other lines of credit, as well as greater flexibility. If you can borrow below prime, and pay it back however you like, including just paying the interest on the loan if you desire, that can be a pretty nice setup.
Using lines of credit, where one can just float the principal and perhaps pay it back when the investment is eventually cashed out, can be a good idea in some cases. We need to be well aware of the opportunity cost of using our available credit this way, and never want to get into a position where we’re borrowing at much higher rates because this lower rate credit is being used for investments.
If that ever happens, this is one case where it makes perfect sense to cash in part of our investments to pay down the line of credit and free it up for this other debt. If you have $20,000 borrowed for investments for instance, and have $10,000 of debt on credit cards, this should be a no brainer, as you are now essentially paying credit card rates on your investment borrowing.
This all needs to be well accounted for prior to borrowing to invest, and one must also make an honest appraisal of one’s future borrowing needs. Often times, people underestimate this, and think that in spite of needing to borrow in the past, this need will somehow magically disappear. It will not simply by trying to ignore these needs, although we can usually have a pretty good idea of what these needs will be by thinking about it sufficiently.
Borrowing to invest can make sense in some cases, when the market may be expected to move in our favor, when we can afford to maintain the loan, and when the cost of borrowing is low enough to make sense of it in comparison to what may be expected.