Is It a Good Idea to Take Out a Loan to Invest? (2024)

Taking out a loan to purchase an asset can make sense in some regards and is even often necessary in a few areas (such as when buying real estate or a business). For the majority of people, however, sticking to their income flow or savings to invest is often the better choice.

The only time when it really makes sense to borrow money for an investment—known in financial lingo as “investing a loan”—is when the return on investment (ROI) on the prospective investment is high and the level of risk is low. Indeed, if you can borrow money at, say, 4% to earn a low-risk 7% return, then it might be worth it. But it is not advisable for an investor to invest a high-interest loan in a risky vehicle where you have some risk of loss, like the stock market or derivatives.

Borrowing to Invest

Taking out a loan to invest, or “investing a loan,” refers to the practice of using borrowed funds to purchase securities, real estate, or other investment assets, with the expectation that the returns on those investments will surpass the cost of the loan, including interest and any associated fees. Certificates of deposit (CDs) and bonds often fit into this category, as do investments that will mature in 90 months or less and carry an expected yield that is greater than 10% of the cost of the loan. While this strategy can potentially yield higher profits due to the increased investment capital, it also carries inherent risks and should be approached with caution.

First, understand that investing a loan requires a higher-than-average degree of risk tolerance. Leveraging a loan to invest increases the overall risk in your investment portfolio. If your investments perform poorly, you could not only lose the invested amount but also be obligated to repay the loan along with the interest, potentially leading to substantial financial losses. If you cannot repay your loan, you may have collateral seized and see your credit score decline.

Therefore, it is crucial to assess your risk tolerance and ensure that you are comfortable with the potential downside. Moreover, because the cost of a loan is tied directly to your credit score, those with poorer credit should avoid taking out relatively high-interest loans for this purpose.

Taking out a loan to invest should align with your overall financial goals and time horizon. If you have short-term financial needs or goals, investing a loan might not be the most appropriate strategy, as the returns on your investments may not materialize quickly enough to repay the loan on time. Similarly, if an investor takes out a loan, it does not make sense to place the money in an investment that will mature after the loan is due.

Before taking any loan, carefully examine the terms and conditions, including repayment schedules, prepayment penalties, and any additional fees. Ensure that you fully understand and can meet the obligations set forth in the loan agreement to avoid any potential legal or financial issues.

Loans Used to Invest

When you use debt to purchase an asset directly, it involves obtaining financing specifically tailored to acquire a particular asset, such as a car loan, a mortgage for a home, or a business loan to buy equipment or inventory. In these cases, the borrowed funds are used to purchase a specific type of asset, and the asset itself often serves as collateral for the loan. The primary goal here is not necessarily to generate investment returns but rather to acquire and utilize the asset for personal or business purposes.

On the other hand, when you take out a personal loan, mortgage, or other type of loan to invest, you are instead borrowing with the intention of using that money to purchase investment assets like stocks, bonds, or real estate properties. The primary goal in this scenario is to use leverage to amplify returns or generate returns that exceed the cost of the loan, including interest and fees.

Investing on Margin

Brokerage firms often allow qualified clients to leverage investments by using margin. Margin allows an investor to borrow funds directly from the broker to purchase investments with the expectation that the returns generated by those investments will exceed the cost of borrowing.

This approach can amplify potential gains by increasing the amount of capital available for investment. However, leveraging also magnifies the potential for losses. If the investment underperforms, the investor will still be obligated to repay the borrowed funds, including interest, which could result in substantial losses. This increased risk makes borrowing to invest a less suitable strategy for risk-averse investors or those with limited financial resources.

Your broker is legally required to obtain your express consent before opening a margin account. The margin account may be part of your standard cash account agreement or may be a completely separate margin agreement. An initial investment of at least $2,000 is required for a margin accounts in the United States, though some brokerages require more. This deposit is known as theminimum margin.

Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as theinitial margin. It’sessential to knowthat you don’t have to margin all the way up to 50%. You can borrow less—say, 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price.

If your investments begin to lose money in your margin account, you may be required to add additional funds to maintain the maintenance margin, which is the minimum account balance you must keep in the account. If the value drops too far below this level, it’s known as amargin call.A margin call is effectively a demand from your brokerage for you toadd money to your accountor close out positions to bring your account back to the required level. If you do not meet the margin call, your brokerage firm can close out any open positions to bring the account back up to the minimum value. Your brokerage firm can do this without your approval and can choose which position(s) to liquidate.

Pros and Cons of Borrowing to Invest

While taking out a loan to invest can offer opportunities for higher returns, it is essential to carefully evaluate the associated risks, costs, and potential rewards. By thoroughly considering your risk tolerance, financial goals, and investment strategy, and seeking professional advice, you can make an informed decision about whether investing a loan is the right approach for your financial situation.

Here are some of the pros and cons of taking out a personal loan to invest:

The Bottom Line

Borrowing to invest—by taking out a loan or using brokerage margin—can amplify both returns and losses. Therefore, taking out a loan to invest is not suitable for every investor, as it involves increased risks and additional financial obligations. This strategy is generally more appropriate for experienced investors with a higher risk tolerance, a stable financial situation, and a clear understanding of the potential benefits and drawbacks of using leverage.

Before considering taking out a loan to invest, it is essential to evaluate your financial goals, risk tolerance, and overall financial situation, and consult with a financial advisor to determine if this strategy aligns with your financial plan.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a qualified financial professional to determine a suitable investment strategy.