Taking out a loan to invest in the future may seem counterintuitive, but it can be a successful strategy if done strategically.
While there are definite risks to using debt to boost your assets, many investors believe that borrowing money today to invest in the future is a good strategy. Although people are taking out loans all the time to buy a house, pay for an education or start a business, borrowing money to build an investment portfolio is more complex.
Efficient vs inefficient debt
Before going down the road of borrowing to invest, take a look at your efficient and inefficient debt. Inefficient debt carries no financial advantage. It’s used to buy goods that don’t generate income, depreciate in value or have no value once they are used and there is no tax deduction, such as a loan to buy a car. Efficient debt is acquired to purchase assets that have the potential to grow in value and/or generate income that can be used to pay back the debt, such as investment property or shares. This kind of debt can help you build wealth over the long term. Keep in mind that having inefficient debt can reduce your wealth due to the associated interest and fees. Consider paying off this debt first, starting with the highest interest fee debt.
Leveraging your portfolio to diversify your assets
If you have a solid investment portfolio, you can borrow against it to invest in another asset class – such as a buy-to-let property. This is better suited to investors who have an appetite for risk, a sizeable investment portfolio, understanding of market volatility and there is a strong likelihood that they will generate a higher return than the cost of the loan. The advantage of borrowing against your portfolio is you don’t have to undergo a formal credit application. However, if the assets fall below the account’s stipulated minimum value, you may be required to find additional funds.
While many people use their home as an asset to borrow against, this should only be done if you know you can pay your home off in the a time frame that aligns with your financial plan; if not, don’t do it. “A little bit of leverage is good, but I don’t recommend borrowing against your home to invest in riskier assets,” warns Carrick Group Commercial Director Anthony Palmer. “Borrowing to invest can help you build your wealth if done in a diversified way, and if the debt is used responsibly, with a clear plan and objective.”
Understand the risks
- Borrowing could increase your potential losses.
- Your losses could exceed the amount initially invested.
- If the investment purchased drops in value or doesn’t increase sufficiently, the cost of the loan may become higher than the profit made from it.
- If you cannot repay the loan, you might have to sell other assets or the lender may be able to take ownership of your investments.
- You may be liable to pay more tax.
Palmer strongly recommends seeking professional advice when borrowing to invest, given the complexity and risks involved and the potential tax implications, and always apply common sense: “Never incur more debt than you can comfortably afford to pay back, regardless of whether it is efficient or inefficient.”