Using Debt as an Investment
Using debt as an investment strategy is highly risky. If you do not have the necessary expertise in investment to weigh the risk appropriately, you should limit your leveraging to only the investment qualified for debt.
In addition, leverage can substantially increase your overall investment strategy risk. If the market or real estate property takes a turn for the worse, your losses may be more than you can financially bear.
Finally, it can be really helpful for your investment to take full advantage of unexpected opportunities. But for leverage, seize those opportunities only if you have substantial excess equity that is available for investment.
The Problem With Leveraging Debt
If you buy a home while you are in debt … that is fine, you don’t think about that because you are able to live in a property without paying for the full price upfront. You take the lowest mortgage rate offered and you live in the house happily ever after.
The same goes for investing in equities also? Maybe not!
Investing in equities is a great way to make money, by putting your money in the stock market and turning it into wealth, but investing in equities for leverage can ruin you.
If you buy stocks or shares in a company and the stock prices –market value— goes up, then you make gain money and you make more money. So far so good! Sounds obvious, but let me travel back in time for a little bit.
80 years ago, a person would sell or gift shares in a company to someone else. That person would buy the shares , add them to the portfolio and by that person’s portfolio, the price of those shares would rise in the market value over time and the person would sell the shares for a higher price. So the person makes a handsome profit and he would have his portfolio, a little bigger over time.
The leveraged investment costs a lot less in the beginning however, is more risky in the long run.
Investments with losses bigger than loans raise a lot of debt.
Although it is possible to earn good returns from these investments, you also have a potential for more losses.
Such investments also require perfect timing since they offer low returns while in the red. The money available in the margin loan for withdrawals or additions is subject to a minimum equity requirement of 30%. If the value of your investment declines below the 30% threshold, then you may have to sell off the shares or use cash from elsewhere to meet the equity requirement.
Loans Against a 401(k)
Credit Card Debt
Credit cards and leveraged investments both provide a convenient way to invest money, but it's important to note that credit card debt isn't the same thing as a leveraged investment. Leveraged investments will magnify any gain you make on a trade. Credit card debt will magnify any loss you make on any trades. Understanding the similarities and differences between credit card debt and leveraged investments is key to making the right decision for your financial future.
Many would-be investors see credit card debt as a valuable way to learn more about trading and practice their strategies without risking too much money. It can also serve as a cushion during the learning process – in the event that you make trades that go against you and skill has not been fully developed.
However, leveraged investments and credit card debt are very different animals. While the complications of leveraged investments can be removed by purchasing and selling through a leveraged trading account, credit card debt becomes more formidable with each transaction.
Here are some key differences to consider:
Credit card debt cannot be sold. If your trades start to go against you, credit card debt will only increase.
Borrowing to Fund Investing
Firstly, if you already have a lot of debt already, it can be better to pay off what you owe before borrowing more money. It’s possible that the loans you may obtain may end up costing you a lot more in the future.
With that said, there are some circumstances in which leveraging debt can be good for you. Leveraging debt can be beneficial if you use it to invest in income-producing properties as this can be good for your financial well-being in the long term.
A good rule of thumb is to borrow up to no more than 50% of the money when it comes to debt, and to only borrow enough to cover about a third of the cost of the investment. You don’t want to invest so much that you forces yourself to be unable to recover if something goes wrong. Also, allow enough room to fall back if interest rates start rising. You may also want to consider paying cash towards the principal so as to diminish the interest due each year.
Aside from the amount you borrow, the term of the loan is also important. A short-term loan can help you save money as you tend to pay less interest. However, it also means that you will have to pay much more in total because you will have to pay the interest every year. You don’t want to pay more in interest than you make in interest earnings.