Can I Take Out A Loan And Invest It?

Can I Take Out A Loan And Invest It in time deposits, bonds, or stocks? Is this a good idea? Personally, my answer is a quick and decisive "No." But this question actually had a twist ending. So let's examine it in more detail.
A while back, while surfing the various forums, I've come across several questions that boil down to: Can I take out a loan and invest it?

Personally, my answer is a quick and decisive "No."

But this question actually had a twist ending. So let's examine it in more detail.

Let's say a bank is offering an insanely reasonable loan: 1 Million, to be paid over 20 years, at 5% interest per annum. Depending on how the interest is computed, that comes to about 4291.67 per month.

The first thought is: Whoa! That's incredibly affordable!

And indeed it is. If it were to buy a house, car, or any other asset there's no point in not taking it. But the scenario isn't that. You would have to mortgage your house to get that loan.

And sure, a lot of investments can beat 5% per annum. But you would have to make monthly payments. That means you can't wait for your investment to earn. You have to start paying now, whether your investment is appreciating in value or not.

So in order to safely invest the money, you'd have to be able to safely pay off the loan, separate from what you would earn from investing the loan amount.

But if I am able to come up with that kind of cash, why can't I just save that amount and invest it? Rather than taking on additional risk by using my house (or another asset) as collateral?

Like we said, if it were to acquire a valuable asset (like a house) it's a no-brainer. But the situation is actually reverse.

So is there some way we can acquire an even more valuable asset, or an asset that will appreciate in value much faster for this loan?

Since it's only a fixed 5% interest, there's a number of ways we can recoup the money.

We could invest the money in the highest-yielding Time Deposit available. Of course, that will hold our money for around 3 months or more. If we want to use the money to pay for itself, we could practice laddering, investing in different time deposits with different maturity dates. But doing so will give me less profit overall, after paying back the loan and interest.

Either way, is that small amount of gain worth risking our house? There are probably safer ways to make that same amount of money.

We could invest in bonds. They're medium-risk and not as safe as time-deposits, but with bigger profits. So we can come out with more in the end.

But profits here aren't guaranteed anymore. Sure bonds are relatively safe, but they also have periods of relatively low profits. So what happens when we redeem portions of our investment during unprofitable times because we need to make monthly payments? We get less profit overall. In the end, we could make more money than in time deposits, but the risk of not making much profit - or no profit altogether - in the end, also increases.

We could place it on stocks. And I've heard it mentioned before. The summary is: It's dangerous. The only way it becomes safe is if we already have enough profits (not holdings - profits) to just absorb the cost of the loan and interest. But in that case, why take the risk?

Here are two takeaways from that scenario above:

1. Sure we have 1.03M or so in profits (on the assumption the loan plus total interest is 1.03M, and we have enough profits to cover it plus interest), but that stock could suffer a correction in a few months or so. What if a disaster happens and businesses are impacted? Any number of scenarios, outside the control and scope of due diligence (technical, fundamental, or quantitative analysis, and the like) can turn a good situation bad. And 20 years is a long time, anything can happen. Potentially, you are just reducing or even nullifying the profit you already made.

2. If you have that much money, why take out a loan?

Of course, if you don't need that house, and you have that much profit to absorb the loan, then it's safe. But in that scenario, you're probably filthy rich and everything is relatively safe - in terms of not wiping you out financially.

So no, we shouldn't take out that loan in this case. But here's the twist: the person who asked the question is actually an OFW in Taiwan. And apparently, inflation was at a record low, so the loan interests are also very low. But more interestingly, the interest rates in the Philippines were still much higher.

And since they can pay off the loan by themselves, regardless of the profit, they invested the money in Philippine Time Deposits. They can afford to look for the highest available interest-rate and wait for the money. And at the time, interest rates in the Philippines were around 9% while the bank loan interest was at only 2%

So what really happened was they got a loan they didn't need to finance a project (house renovation) they could afford, so they could end up with more money in the end. Amazing right?

In this case, it was the correct use of leverage.

(By the way, if you're juggling between saving, paying debts, and investing, I've got a money management strategy that will work for you.)

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photo credit: Martin Whitmore via photopin cc

1 comment:

  1. Nice post. i am interested to apply for a personal loan but after reading this post i think i can use that amount for investment purpose. thanks for sharing.