Going Into Debt To Invest Money?

Sam wrote in with the following question:

I currently have no debt and am thinking of investing in the stock market. I can get loans with very low interest rates (4-5%) and can also do some credit card arbitrage to get money for a while at 0% rates. Should I take out these loans to invest in long-term stocks, given that most people estimate that stocks will earn 10% annually over the long term?

I don’t have the definitive answer to this question. Why? Because there isn’t one.

Like many other investment choices, this one is intrinsically tied to a person’s risk tolerance. This scenario actually has multiple dimensions of risk: the risk of incurring debt and the risk of investing in the stock market. Let’s look at both of these.

The risk of debt. Any time you incur debt, you’re basically promising that your future self will be able to pay off the debt. While Sam is in great financial shape now (presumably having a good job and so on), the future may bring a spouse, a child, job loss, etc. These are potential risks any time you incur debt. Obviously, the more tenuous your situation is now, the riskier the debt is – for example, if you rack up debts that your current self simply can’t pay, you’re actually betting that your future will be significantly better than your present.

The risk of stock investment. Any investment in the stock market has risk associated to it – past performance is never a guarantee of future returns. The Vanguard 500 has returned an average of 12% annually since 1976 – it may be reasonable to assume that level of return as a thumbnail, but if you legitimately expect that return every single year, you’re going to be disappointed. In any stock investment, there are going to be periods of losses.

Combining the two risks. Where things get really shaky is when you combine the two. Let’s say, for instance, that you worked for a dot-com startup in 2000 and you took out debt to invest heavily in the stock. By 2002, there’s a decent chance that you would have been out of a job, been facing this debt, and the stock you owned would have been nearly worthless.

The success here, however, could be tremendous – in essence, you could make free money. Let’s say you buy a stock that doubles up in a year, then you sell 70% of the stock to pay your debts and pay the taxes incurred. Suddenly, 30% of those shares you bought are now yours for free – and we’re not even looking at dividend earnings, either.

Sam’s idea is not a bad one, just a risky one. It’s far beyond my risk tolerance to invest in the stock market using borrowed money, but for others, the risk may in fact be tolerable.

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  1. Jason says:

    The answer to this one is easy:

    Don’t buy stocks with a credit card.

  2. eR0CK says:

    IMHO, absolutely not.

    That 10% isn’t guaranteed and if you go long on the wrong stocks you could be up the river without a paddle.

    You could do this with mutual funds, just to be safe and have a diversified less volatile fund, but you’re still putting yourself at risk.

    Like Jim Cramer says, “Bulls make money, Bears make money, but Pigs get slaughtered”

    Just imagine if you take out a $5,000 loan and $5,000 in credit card arbitrage and lose everything? If you don’t even have the disposal income to invest today, how on Earth would you pay-off the $10,000 loss you suffered?

    Just something to consider.

  3. Ted Valentine says:

    If its a good idea, he should borrow as much as he possibly can on low interest credit cards and signature loans and invest it all.

    I’d go for something that offers a little more expected return, myself, like small cap value international. Why play it safe at this point with boring large cap growth US stocks?

    Yeah, why not? He can net 10%! And that’s conservative, right? Easy money. So easy a caveman could do it.

  4. Ryan says:

    File this one under: “Don’t try to beat the odds if you can’t survive the odds beating you”.

  5. Javi0084 says:

    Too risky for me.

  6. alex says:

    When he says he can get loans at 4-5% is he talking about credit cards? The current 30 year mortgage rate is like 6.7% so I don’t understand where he is getting 4-5% from.

  7. trb says:

    This is beyond my risk tolerance, too, and unneccesary.

    Sam, how are you planning to pay back that debt you incur? By making monthly payments, probably. So, instead, figure out what it would cost you to pay back a $10K loan at 4% over two years, and instead of sending that payment to the bank or credit card, start investing it.

    You don’t need to have a big amount to start with, if you are putting investment money in steadily. Why would you accept a ~6% return (10%-4% loans), and risk losing everything, when you could have a ~10% return with only your disposable income risked?

  8. Dave says:

    As everyone else already pointed out, it’s an awful idea. Investing with a credit card means the money will have to be paid back relatively soon, and in the short term, the stock market is very volatile. There’s nothing wrong with buying the market to sell in 10-20 years, but buying it to sell in 1 year is nothing short of a gamble.
    Also, let’s not forget taxes. To pay off a 5% loan, you may need to earn 7+% before taxes.

  9. Madd Hatter says:

    Our friends at CNNMoney can handle this one for us (it’s about pulling home equity vs. credit cards but the truths still hold). http://money.cnn.com/2007/07/16/pf/expert/expert2.moneymag/index.htm?postversion=2007071906

  10. Sense says:

    Why not park the cc arbitrage principal in a high yield savings account and invest the interest it generates in the stock market? That will protect the sum you need to pay back, and you can keep the interest in the market even after you have to pay the cc back.

    Assuming you are vigilant with those cc arbitrage details, it is the best of both worlds, in my opinion.

  11. cami says:

    How is this different that buying stocks on margin? The cc arbitrage is no guarantee, it could be gone before you have the time to wait out stock market volatility. Isn’t this how people got wiped out in the 20′s (margin calls)?

  12. Mike says:

    You might as well say putting your life savings on red at the casino roulette wheel isn’t a bad idea, it’s just risky.

    I could see doing this in a small way–technically anyone who’s carrying a mortgage and has a non-retirement stock portfolio is doing this. But like any risky investment, you need to caveat it with the standard “don’t invest money you can’t afford to lose”.

    In general though, for the vast majority of people, I think the idea of borrowing money specifically to invest just doesn’t make sense. The potential rewards are not worth the very real risks.

    In the specific case of this person’s question, they’re in a great position having no debt, and can invest their spare income without incurring debt. Why take the risk of losing that great position, becoming mired in debt for what I would describe as a small potential increase in return?

  13. Ursula says:

    I beg to differ. There IS a definitive the answer. That answer is “NFW!”

    What an incredibly stupid thing this would be to do. Sam, don’t do it dude! If you’re debt free, then take money out of your paycheck and invest it. Do not go into debt to invest!

  14. MVP says:

    Better yet, take the loan and head to your nearest casino. This is an absolutely terrible idea, in my opinion. But if you’re someone who likes to play games with money, it might be the perfect plan for you.

  15. joe says:

    Well, I just took out $2750 in consumer debit in the form of a 0%, $0 fee balance transfer for 1 year. At this point, my idea is to put that money into my Zecco Roth IRA and use it to buy various stocks. In 10 months, I take my principal investment out and keep the interest working in my IRA. Although the chance to make money on this deal is appealing, another reason that I’m doing it is to force myself to look carefully at stocks and learn about the stock market. I’ll be tracking my progress at my website, under30finance.

    A few key points:
    - IRA earnings are not subject to capital gains.
    - The original principal investment can be deducted without penalty
    - I plan to diversify my portfolio between several stocks
    - I can sustain losses up to 20% without major calamity, though I defintely don’t want to.

    Also, I regularly contribute hard earned cash into my IRA, but the opportunity to get a large lump sum to play with, in my opinion, shouldn’t be passed up. That losing on this deal will “hurt” motivates me to make it a winning deal. Finally, no matter what, I will pay off the entire amount I borrow before the 0% period is up in order to not incur any finance charge.

  16. Brip Blap says:

    I had to laugh when I read this article – first, because using debt to invest is laughable, and second, because I just finished writing a post about this right before this post appeared on The Simple Dollar, and now I’m going to look like a copycat! Talk about timing. Mine will have to sit on the bench for a while now.

    Can’t echo it enough – bad, bad idea.

  17. Matt says:

    Too risky for me.

    But, I did take out $1,500 extra in student loans one semester to max out my IRA before April 15th? I had it all paid back within 2 months. I knew the money was coming I just had to wait for it. Sure I paid 8% interest on $1,500 for 2 months but the key to this equation was time, something that I could not have gotten back. And the positive was that for those 2 months I earned more than 8% interest, so it turned out win win but I was not expecting that.

    I’ve been looking into cc arbitrage and the prospect for earning high interest rates is very tempting. Being $50,000 in debt on top of my current debt is something I can’t and don’t want to deal with now. So it’s either savings accounts or CD’s for me, or none at all.

  18. Matt says:

    I just thought of this after I posted my comment.

    People borrow money to invest all the time. How about:

    Houses
    Investment Properties(apartments and what have you)
    Businesses
    Higher Education

    Then there are the things that will definitely decrease in value:

    Cars
    Credit Card debt(how about that night at the bar 2 years ago? what’s that worth now?)

    Is investing in the stock market with borrowed money worse than going into credit card debt? At least the stock market might increase in value.

    Just a thought.

  19. Dave says:

    Matt,
    That night at the bar 2 years ago was not an investment.
    Neither is a house for most people.

    Yes, you can borrow money to earn higher returns (such as on investment properties). It’s called using leverage, and allows you to get significantly higher returns, or significantly worse losses.
    It’s worth pursuing only if you can handle the losses. Someone who doesn’t have enough money to invest in the first place clearly can’t handle the losses.

  20. Ted Valentine says:

    Borrow all you can. Put all in the market. If you believe in this put your money where your mouth is. Leverage all you can. If it doesn’t work (which will never happen) just file bankruptcy. Go for it!!!! Everybody is doing it.

  21. Tim says:

    the key is risk tolerance. we all have different risk tolerance levels.

    borrowing to execute a margin call isn’t any different than borrowing from any other source, nor is it any different than choosing highly volatile penny stocks versus blue chips, nor is it different than investing in stocks or funds versus putting money in cd’s or interest bearing accounts. The difference is in the degree of risk you are willing to tolerate. you can leverage many more shares if you borrow, but again you have to weigh the risks involved. those of you who wrote NFW or it’s absurd to borrow money, just do not have the higher risk tolerance levels. people and companies borrow every day to leverage more buying power. if you invest in real estate, you are doing the same thing by borrowing.

    if you are going to borrow, you definitely need to do research as you normally would when investing. if you are going to do it off a “hot stock tip”, i’d say you probably are setting yourself up for failure but that is just me. in your case, if you have sufficient money to cover, i personally would do it especially with 0%. i would look at high yield dividend companies if you want to take less risk. i am currently doing this.

    i’d also probably look more into borrowing as a back stop to covering margins rather than direct borrowing to invest. this way you can mitigate some losses by putting the borrowed money in t-bills or high yield savings or laddered cd’s.

  22. Tanya says:

    This may be a dumb question, but wouldn’t putting so much on your 0% credit card be bad for your credit, whether you paid it back when the 0% was over or not?

  23. joe says:

    One of the main things your credit score looks at the is the ratio of your used credit to available credit. For instance, if you have 5 credit cards with $2000 limits, your total available credit is $10,000. When you use $5000 of that credit, your ratio goes to 50%, meaning you’re using 50% of your available credit. This can negatively impact your credit score. However, in my case, my available credit is $42,000, and I’m only using $2750, so the impact to my credit score will be minimal.

    The answer to the second part of the question is that the balance you carry on credit cards will stop negatively impacting your credit score when you pay it off.

    At that point, you’ll be building credit history and it will positively affect your credit score.

  24. Amy Haden says:

    Just loved Ted’s answer! All I can say is, what’s old is new again — back in the roaring 1920′s everyone was borrowing like crazy to get all they could into the stock market (getting interest-only mortgage loans was very popular) and everyone was investing every bit of money that they could because they felt that they could not lose. Then something called a stock market crash happened, leading to the Great Depression. Need something more recent? Just ask anyone who mortgaged their house or used all their savings in the 1990s to get into tech stocks. Think that maybe these folks who lost everything weren’t clever enough, or that their portfolios weren’t diversified enough?! Diversifying is indeed the way to go, but I’d never borrow a dime to take even a diversified gamble.

  25. Margaret says:

    I think it’s not necessarily a bad idea to borrow to invest. I would be really cautious about using the credit cards as the source of the loan, though. I would only use the credit cards if, for instance, I KNEW I could invest $500 a month for the next 6 months. Then I might use the credit cards to get $3000 now to invest in a lump sum (which could mean lower transaction fees depending on your investments), and then pay off the credit card over the next 6 months.
    If you borrow, perhaps you can deduct your interest expenses (you can do this in Canada for non registered investments).
    If you are in a situation where investing the lump sum now makes a significant difference, then sure. Eg if you are investing in your RRSPs (Canada) and you want to get the maximum deduction that particular tax year.
    If you are just a beginner invester, though, I wouldn’t recommend this, except for the RRSP purpose, and then only if you would have the loan paid off within one year. What if it turns out you are a terrible investor? If you are a savy investor, then you probably already know whether or not you would be comfortable borrowing to invest and what the risks are.

  26. kitty says:

    Not for me. I can contemplate the idea of putting money borrowed at 0% in a high-yield saving account, CDs or treasury bills, but not in the stock market. I firmly believe that the money you invest in stocks should be money you can afford to loose. Not necessarily want to loose or like to loose just afford to loose without being wiped out. I don’t buy stocks on margin either. If you have to repay your loan, you don’t have 20 years to wait until stock market goes back up. The only exception I can contemplate is if you have the same amount of money you are borrowing somewhere, just not immediately available. For example, if you have enough money in a CD that matures before your loan interest goes up, then it may be OK to borrow. In the worst case, you can just take the money from the CD. But you should really be able to afford to loose the money.

    Still haven’t gotten back some of the money I lost when the internet bubble birst. Maybe I didn’t invest in the right stocks, maybe I have too much in my company’s stock, maybe I didn’t sell in the right time. But you cannot expect to always guess right. Nor can you count on the index performance – just look at 20 years preceding 1987 crash.

  27. kitty says:

    One more thing – or rather question. I am wondering if the fact that people are discussing borrowing money to buy stocks maybe a signal to get out of the market? Is there any way to find out the percentage of the borrowed money now in the stock market?

  28. Matt says:

    I second this comment of Margaret’s “If you are just a beginner investor, though, I wouldn’t recommend this”

    As a beginner investor you have know idea how you would react to a loss. I’d say after you’ve been investing for five years then you can figure out if you’d like to invest on margin.

    Also, read “The Intelligent Investor” before you do start.

  29. I think this is excellent advice particularly in light of the recent credit crunch and shaky gloal stok markets.

  30. vexacioussugar says:

    Very interesting argument for both sides. I am in a similar position right now…thinking about using a 0% credit card to invest $10,000 in one particular stock that is expected to triple in value soon. I already do automatic investing, putting in a few hundred bucks each month. But right now, with stock prices at historic lows…seems like there is huge earning potential if you buy a lot of shares at a discount. There is one stock in particular that my advisers, who have over 30 years experience, believe will triple in value. They also believe this stock won’t get much lower. It’s about $0.70/share right now, expected to hit $3 or $4 a share…so it’s very tempting to borrow money so I can buy a large quantity of shares at a bargain. With 0% interest, seems like an easy way to make a nice profit without doing much…and I can shuffle this balance around between my cards until it’s paid off. But it’s a very iffy decision.

    I wish I had a ton of extra cash saved up that I could invest, but the reality is that I only have a few months of living expenses saved up. I’m in pretty good financial shape right now, but I’m not debt-free. If I lost every penny of the $10,000, that would suck, but it would not “wipe me out.” If I lost my job for some reason, I’m confident I could find work fairly quickly given my experience. Only thing that would screw me bad is if I was seriously injured or hospitalized, preventing me from working. That could impact my ability to pay back the debt. Even though I don’t expect something like that to happen, you never know.

    I actually did a decision matrix on this, comparing borrowing $10k, $5k, borrowing nothing, or spending all of my savings. I varied the weights, and the results were always the same: not borrowing appears to be the best option. But it’s so tempting. And yes, it is a big gamble. Perhaps it’s similar to the type of financial behavior that got our nation into the current economic mess. It goes against my own personal rule of finance, never taking credit on something. If you don’t have the money, you can’t afford it yet. At the same time, I wonder if I can afford to miss out on a big and easy earning opportunity. The answer is, of course, yes. I lose nothing by gambling nothing. And there are, undoubtedly, less risky ways to make big profits. But the greed kicks in, and I think, “Wouldn’t it be nice to suddenly have a down payment for a house.”

    I may compromise with myself and borrow just $5,000 instead of $10,000. If I do earn something, I’ll be sure to donate a portion of it to charity.

  31. Ralph says:

    Thanks for your honest answer regarding making long-term investments. I think what you stated that even low-risk investments aren’t completely guaranteed to make profits given the present state of the economy is spot-on. Good tips.

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