The Risk of Borrowing Money to Make Market Investments

The Risk of Borrowing Money to Make Market Investments

The risk of borrowing money to make market investments

 

Have you ever heard of the phrase, “it takes money to make money”? To a large extent, this is true as you reap higher returns from larger investments. And so, given that many of us lack the capital to enter into larger investments, we may be tempted to borrow money to make up the shortfall.

Gearing, or more simply stated as borrowing to invest is one viable option when attempting to make larger investments. However, it does not come free of risks, in fact it can be taught of a leveraging multiplier tool where both the risk and potential returns are exponentially increased. Additionally, there are other benefits and less obvious risks that gearing poses. In this article, we aim to give a brief overview of the factors that you should carefully weigh before you decide to get a personal loan in Singapore.

The pros of gearing

Intuitively, gearing is able to give you a higher amount of cash on hand, thus allowing you to start investing in more costly financial instruments that you would otherwise not have been able to afford. Additionally, depending on current governing policies, you may be granted tax deductions for interest payments made on the loan.

The cons of gearing

Four types of common risks exist when you borrow to invest.

  1. Investment risk. The investment may not produce the expected level of income or dividends. In such a scenario, the investment’s returns may not be sufficient to cover the cost of your loan. In this case, you will need extra funds to maintain your investment.
  2. Interest risk. Given that larger investments are typically taken on with longer time frames, if your loan has a variable interest rate, you should be prepared for the risk of the interest rate increasing. Essentially, if the interest rate were to rise a couple of percent, would you still be able to afford the repayment?
  3. Income risk. Most of your initial calculations are likely to assume that your income remains relatively stable, thus affording you disposable income to make the loan repayments. However, if your income were to cease due to medical reasons or redundancy, you will need flexibility in your plans to deal with such a contingency.
  4. Capital risk. Not all investments pan out as planned, as there are tremendous causal ambiguity and social complexity in any investment. Consequently, you need to prepare emergency funds to deal with such a risk.

Given these risks, should I borrow to invest?

Where you foresee relatively high and stable future returns on an investment, gearing can be a powerful tool to help get you into the game. Ideally, you will achieve positive gearing, where the returns on the investment rolling in will be sufficient to cover your monthly repayment loans in Singapore. Conversely, you will hope to avoid negative gearing were returns are less than payment owed.

Additionally, gearing is typically a medium to long term strategy, with returns arriving later in the timeline, thus requiring you to have plans for affording the loan in time. During which, sufficient financial flexibility should be maintain for contingencies. To help reduce risk, you should consider diversifying by spreading your investments. This safeguards you from a single negative economic event which might wipe out your geared investment.

Without a thorough understanding and accurate forecasting of both the returns and risks, you may find yourself deep in debt. As such, gearing is typically only used for experienced investors with sufficient appetite for risks.