You’re making big returns on the money that you’ve invested — that’s great! So if you could get your hands on some more cash, you could invest it too and make even more money, right? Maybe not.
We’re big fans of investing — it’s the best way to grow wealth for your future. When done correctly, regular investing can make you a millionaire over the course of your lifetime. And some savvy investors can make big returns quickly by getting involved in the right opportunity at the right time. But just like there are great tactics in the investment world, there are also some bone-headed strategies that can cost you a lot of money in the long run.
In this series, we’re discussing some of the “Do’s and Don’ts” of wise investing. Today’s lesson is an important one for anyone who is doing well, and thinks that they could do even better if they had more cash: Don’t ever borrow money to invest, or invest more money than you can afford to lose.
If you’ve read much on this site, you certainly know that we’re not fans of debt. Running up personal consumer debt is a great way to ruin your finances. Some people think, though, that it’s okay to borrow money to invest, because the income on the investments will be more than enough to pay back the debt. In the perfect world, that may work. But in our real world, it’s a bad idea.
There are a number of ways that people use debt to invest. Hopefully you’re not foolhardy enough to take out a cash advance on your credit card or a home equity loan to go play in the stock market… but people have done it, and lost big. A more common tactic is something called “margin trading.” If you have an account with a stock brokerage, that broker may offer to let you invest more money than you actually have in your account (up to twice as much cash as you have). The extra money is deceivingly called “margin,” but in reality it’s just money that the brokerage is lending you. If you make a profit off of that margin investing, all is well. If you lose money, though, you have to pay the brokerage back for the money that you’ve borrowed, meaning that you’ve really lost twice.
Another form of borrowing to invest is taking out mortgages to get into the real estate world. This was hugely popular in the past 5-10 years, when everyone and their uncle decided that they could make money by “flipping” houses — buying them cheap, fixing them up, and selling them for a profit. People borrowed money to buy these houses, and a lot of folks ended up losing their shirts.
Other people borrow money to buy rental properties, hoping that the rental income will be enough to pay back the loans each month.
So, why is borrowing to invest a bad idea? Because investing is inherently risky business, and borrowing increases that risk to an unacceptable level. If you lose your own money, that stinks, but you can recover. If you lose someone else’s money, though, they’re going to demand that you pay it back. And that can break you.
Here’s the thing about investing: We should only invest money that we can afford to lose. Investing is what you do with the cash you have leftover after you’ve fed your family, paid your bills and given generously. You hope to make a profit with this extra money. But even if you don’t — even if you lose every penny of it — you haven’t done permanent damage to your financial life. You still have plenty of cash to keep the lights on and feed your kids. Losing this money on an investment is no fun… but in the end, it’s really not a big deal.
If you’ve borrowed money to invest, though, losing it becomes a big deal very quickly. All of the sudden, you haven’t just lost your extra money, but someone else’s money as well. Though you hoped to make a profit on that borrowed money, losing it is always a possibility. When you lose it, you have to pay it back out of your own personal finances. And that means that the money you use to feed and clothe people now has to go to your lenders. Borrowing money to invest can put your family in serious financial jeopardy.
Here’s the truth: Borrowing money to invest only works out well if everything goes perfectly. It only works to invest on margins if your stocks are always going up. It only works to take out a mortgage to flip a home if the project goes off without a hitch. It only works to borrow money to buy a rental if the place is always rented and never needs repair. But of course, that’s not the world that we live in. Stocks go down from time to time. Fixing up a house is almost always a slower and more expensive proposition than you think. And ask any landlord — they’ll tell you that it can be difficult to find tenants, and there’s always something in a rental property that needs fixing.
We live in a world where stuff goes wrong — there’s no avoiding it. If you’ve borrowed money to invest, bad breaks can send your right into bankruptcy. Do yourself a favor and avoid the allure of big gains that come along with risky bets. Only invest money that you can afford to lose. Then you can enjoy your investment gains worry free.
Photo by Steve Johnson. Used under Creative Commons License.