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If you’re interested in wealth creation you may have considered borrowing money to invest in shares you could not purchase outright otherwise. While this approach has the potential to be lucrative, it’s also considered a medium to high-risk strategy and needs careful consideration before you take the plunge. It’s also not a suitable approach for every investor and is typically more suited to experienced investors with higher tolerance and financial stability. Let’s unpack the complexities.
How does it work?
If you’re planning to borrow to invest in shares there are a few ways you can approach this. You may consider a margin loan. This type of loan lets you borrow funds to invest in shares, EFTs, and managed funds. With a margin loan, you’re purchasing shares at a fraction of the cost compared to what you would pay upfront. The lender will then use these shares as security against your loan. According to CommSec executive general manager, Richard Burns, there has been an increase in this approach recently. “The low interest rate environment is creating more interest in this strategy,” says Burns. “We are seeing more of our customers lock in lower rates through a fixed-rate option over 1-2 years.” There are several other loan types including personal loans and investment property loans which may also be worth considering. Alternatively, you may choose to use the equity in your home to borrow against. In most instances, you would have a lower interest rate with this strategy as opposed to a margin loan. Any type of finance you access for the purposes of investing will have unique features, interest rates and eligibility criteria. Regardless of the finance you obtain, you need to consider if and how this approach aligns with your overall financial goals and your future. This approach is normally a mid-long term period which means if you’re looking for ways to increase your finances short-term this likely isn’t a strategy for you.What are the risks associated?
If you’re borrowing funds to invest in shares you’ll have more money to invest and while this can help to increase your returns, there are also greater risks and even potential complexities around your tax rate and deductions, including:- Interest rates: Depending on the interest rates, your interest may outweigh any profits you make.
- Capital risk: The value of your investment shifts with the market meaning it can go down. If you need to sell your shares you may not cover the loan balance.
- Investment income risk: It can be challenging to predict the income from an investment and it may end up being lower than anticipated. For example, you may find yourself in a situation where a company doesn’t pay a dividend.
- Standard risks associated with the share market: there are a range of standard risks that apply when investing in the share market including capital loss, volatility and no guarantee of dividends. These would apply to anyone investing in the share market but are perhaps even higher risk when you’re borrowing funds to invest.
- Credit score risk: If you miss payments or are unable to pay back the loan, you will likely see your credit score impacted and potentially have collateral seized.
What are the benefits?
While there are risks involved in borrowing to invest in shares, there are also potential benefits including:- Keeping in mind that this is a long term investment strategy, you could increase the value of your portfolio by earning more than you would in interest therefore amplifying your returns.
- There is flexibility to buy a range of different assets or securities.
- Borrowing to invest is considered ‘gearing.’ There are potential tax efficiencies associated, however, these can vary depending on your unique set of circumstances and whether you are negatively or positively geared. We recommend speaking with a financial planner or an accountant to understand the potential benefits you may be able to access.
Reduce your risks
To some extent, there will always be risks associated with any form of investing. However, you can take steps to minimise these risks. These include:- Diversify your assets: Diversifying your assets simply refers to investing across different asset classes - for example, shares, property. Bonds and private equity. Then you can further diversify your options within each asset class.
- Have cash set aside: Have an accessible emergency fund where you can access finances quickly if unexpected things pop up. Ideally, an investment strategy is long-term so you don’t want to be forced to prematurely sell off investments because you’re in need of quick cash and this will likely impact your overall performance. Ensuring you have a diversified portfolio will help to protect you should a single company or investment fall in value.
- Shop around for the best loan: Choosing the loan that’s right for you can help to save a lot in interest and fee. Loan features may also vary which is why it’s important to research and consider a loan that best suits you
- Avoid the highest loan: Don’t borrow the maximum amount offered. Borrow only what you need. The more you borrow, the higher the repayments and the more interest you pay.
- Pay your interest: Meet the monthly interest repayments and pay extra when you can to reduce the overall cost of the loan.
