Borrowing to invest – How it works and the risks involved

It’s important to understand the risks before you consider getting an investment loan.

Whilst you may get larger returns when your investment value increases, it can result in larger losses when the value falls.

How it works

A time frame of at least five to ten years is considered prudent when borrowing to invest.  Investment property loans and margin loans are typically used. With the investment (shares or property) used as the security for the loan.

Investment property loans can be used to invest in houses, apartments or commercial property.  You can collect the rent on the property but you also have to pay loan interest and the costs to own the property (think land rates, insurance, property maintenance, agents fees etc).

Typically the lender will look to cap the amount of the loan to 80-90% of the value of the property meaning you’ll need to put in the difference or offer additional property as security.

Margin loans enable you to borrow funds to invest in shares, managed funds and ETF’s, using those investments as security for the loan.

Margin lenders require you to keep the loan amount below an agreed level of the value of the investment, usually around 70%.  This is called the loan to value ratio (LVR). The LVR goes up if the investment falls in value and if the agreed LVR is exceeded the lender will issue a margin call.

To get the LVR back to acceptable levels you can deposit money to reduce how much you owe on the loan, add more shares or managed funds to increase the investment value, or sell part of the investment and use the money to reduce the loan balance.

If you can’t meet the margin call the lender will sell some of your investments to reduce the loan (and it may not be a good time to sell).

Margin loans can be a high risk investment  and you can lose a lot more than you invest if things go against you.  If you don’t fully understand how a margin loan works and the risks involved, don’t take one out.

Risks

The major risks of borrowing to invest are:

• Capital risk – The investment value can decrease. If you have to sell the investment at the wrong time it may not cover the loan balance
• Bigger losses – You need to repay the loan and interest regardless of how your investment performs
• Investment income risk – The income from an investment may be lower than you expect. For instance, a tenant may move out and you don’t receive rent for a period.  Another example is that a company might not pay a dividend.  Take measures to ensure you can cover all costs if you don’t have enough income from the investments.
• Interest rate risk – If the loan is on a variable interest rate then payments can potentially increase. Would you still be able to afford the repayments if interest rates increase?

Borrowing to invest really only makes sense if the return after tax is higher than the costs of the investment.  If not, you will have taken on a lot of risk for a low or negative return.

It’s very important to seek qualified financial advice when considering a gearing strategy.