Borrowing to Invest: Does it Make Sense?

A lot of financial counselors are now suggesting to their clients that they should borrow money on their home with the use of a home equity loan to invest into the stock market. These people of course are earning a nice big commission from selling the home equity loan and are probably pushing the idea for that reason alone. If you're being offered a home equity loan at 7% to invest in the market, it probably won't make sense to borrow that money to invest, but are there ever any situations when one should borrow to invest?

Unfortunately, there's not a clear and easy answer here. It all depends on your risk tolerance. There's the risk of investing the money in the stock market, and the risk of incurring additional debt. Some people who are more risk adverse such as myself would choose to minimize our debts and invest later when we have money. Others, such as my room-mate mike, will borrow anything he can at a decent rate to invest in small-cap mutual funds. He might come out ahead with his venture, but no one can say for certain.

It's just a matter of how much risk you're willing to take. First, there's the risk of borrowing additional money. You're essentially agreeing to pay money in the future for the money that you have now. There's always the possibility that they money won't be there to pay off the debt because of a job loss, death in the family, or something of the sort. If you're debt free, have plenty of savings, and make a good income, incurring a little debt isn't very risky. If you don't make a ton of money, already have a car payment and credit card debt, incurring more debt is probably a poor idea. You're already close to the edge, you don't need to move any closer to it.

There's also the additional risk of the investment. Investing in the stock market is by no means a guaranteed return. The $4000 I invested into VFIFX at the beginning of the year is worth about $3978 as I write this. I know that over the next 40 years it'll probably make a lot of money, but there's never a guarantee. The stock market could go down significantly in the near future, or it could reach another set of new record highs. We do know that over a very long period of time you can easily average 10-12% in most mutual funds.

When you combine the risk of the added debt and the risk of investing in the stock market, it becomes a major consideration. Imagine if you tried something like this right before the dotcom bubble, lost your job and then your investment when down the tubes, ouch! You could also be very successful if you did this at the right time. If you borrowed money in 1995 and left it until December of 1999, you'd come out with a nice pile of cash from your venture, but you're never going to know ahead of time.

If you can get someone to loan you the money at a relatively low interest rate and want to take the risk, go for it! If you're more risk adverse and would rather be certain in what you have , borrowing money to invest probably isn't for you.