An investment made using borrowed funds is called 'leveraged investing' or 'gearing' in financial parlance. And most personal finance experts consider it as a sure shot path to financial mess and hence should be strictly avoided as in over 50% of such cases where the investor invests in either stocks or mutual funds using borrowed funds to make fast bucks in short-term end up with a negative portfolio.
It is because stock markets do not follow a linear fashion and indeed are volatile. More so, the market risks involved when trading in derivatives or the Futures and Options segment of the secondary market is all the more
Before you take on such a decision, here are some questions you should seek answer for:
1. Is the return from the investment instrument being considered is guaranteed?
2. Will it make up for the loan cost and other processing charges?
3. Is your investment decision using borrowed funds worth the risk?
4. In case the actual returns from the investment do not meet the estimates, how will you pay back the loan?
Pros and cons of investing in equities using borrowed funds
Though the benefit when considering the risk at stake when borrowing to invest is far-fetched, nonetheless it can be rewarding when the markets are on the rise. But it is not always the case, as prolonged bear market is not a new phenomenon in the stock market.
At the same time by borrowing to invest, investors gain access to more funds besides their own corpus available for investment. Plus there are tax benefits that you can claim as tax deduction in respect of the interest paid on loan amount in many a case.
But remember when proceeding to borrow such funds for making investment decision in stock or mutual funds, your after tax returns from such a portfolio should be more than the overall cost of the loan that includes processing fee, interest and other charges.
Risks involved when borrowing to invest
First of all such a strategy does not works for those who cannot afford to lose the debt secured for making investment. Also, if at all you have the nerve to head for such a high-risk financial decision, it will be wise to consult a financial advisor to draw out a plan to deal with the different risks involved:
1. Investment income risk: There can be a shortfall in the returns i.e. the actual returns can be lower than expected. And to meet the gap, you need to have some funds kept aside to meet the cost of the loan.
2. Invested capital risk: There is no guarantee when it comes to returns from investments in equity, equity-backed mutual fund schemes, IPO. One can be even witness to 100% erosion of his capital invested and this can be detrimental given the fact that you need to pay back the loan amount together with the interest irrespective of the fact whether you realize gains or loss from the investment made.
3. Interest rate risk: There are also instances when the interest rate on loan taken (in case of a floating rate scenario) can increase by 2-3% and in such a case it is highly likely that your investments fail to meet the additional expense. Hereon, you would need to juggle out with your budget to repay the EMI.
4. Income risk: There can also be a case that you due to some contingency are no longer able to earn now so this also raises a big question if at all you lose a substantial amount by making such a stake.
5. Concentration or liquidity risk: When you choose to invest in some single stock and that underperforms due to some near-term negative outlook, you are at the danger of concentration risk. Liquidity risk is when you take exposure in some small cap or penny stock that in some time becomes illiquid and no longer traded on the bourses.