School Didn’t Teach Me: How to Make Investments With Loans

Borrowing money to invest is known as leveraged investing, and it can amplify your results, for better or for worse. Maybe it’s just as well that schools don’t teach this in the classroom!

We’ll start with an important caveat.

Taking a loan to invest only makes sense if the cost of borrowing is less than the returns from your investment. The idea is to use your investment returns to offset your loan, while still enjoying profit.

If the cost of borrowing is on par – or worse, exceeds – the returns from your investment, you’ll end up not making any money, or even lose money. This defeats the purpose of investing in the first place. 

Therefore, we can derive two guiding principles when investing using loans. One, the investment should be low risk and provide high returns, and two, the investment should be fairly liquid, and should mature before the loan is due. 

By now, you have already realised that common retail loans such as personal loans that require monthly repayments, and balance transfers that are due in a few short months are not very suitable for investment purposes. 

And let’s not forget that many common investments available to retail investors simply don’t offer a high enough return, have a long maturity period, or are too volatile. 

So, how exactly does one go about making investments with loans? 

Leveraged investment is the answer

Investing using borrowed funds is also known as leveraged investing.

In leveraged investing, you take a loan from a bank, using the existing assets in your account as collateral. With your loan backed by your bank assets, the risk to the lender is lowered. 

With lower risk, the lender is able to charge lower interest on your loan, which means the reduced cost of borrowing for you. 

This is important for leveraged investments to work. Remember how one key principle is having the cost of borrowing be lower than your investment returns? Therefore, the lower your interest rate, the better for you. 

In contrast, personal loans are unsecured, which means the interest rates are comparatively much higher. This makes leveraged investing using personal loans impractical in almost all scenarios – it’s difficult, if not impossible, to consistently achieve high enough returns that outstrip the interest on your unsecured loan. 

There is another reason why leveraged investments can work well. By increasing your investment capital using borrowed funds, you can reap greater total returns. This can translate into a higher return-on-investment, making investing more lucrative with leverage than without. 

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Leveraged investment in action

Now that you understand the advantages of leveraged investing, let’s take a look at how it works with a quick example. 

As you can see, investing using leverage can significantly improve your total profits and provide a better return-on-investment rate. You gained a total of S$112,500 compared to S$60,000, even after paying off the interest on your loan. 

But before you go running off to start your own leveraged investing, know that leverage is a double-edged sword. 

What are the risks of leveraged investment?

Investment makes a loss

In the example above, the investment managed to provide a gain of 6%. What happens if things go the other way?

In this scenario, your investment made a loss of 4%. Without leverage, your total loss would be limited to S$40,000, equal to -4% return-on-investment.  

However, with leverage investment, your total losses are now much higher, at S$137,500, equivalent to a -13.74% return-on-investment.

This is because of the interest on the loan, which is payable whether your investment makes a gain or a loss.

In a nutshell, using leverage when investing amplifies the results you get, whether you make and gain or a loss. In fact, investing with leverage can cause your losses to exceed your capital. 

For that reason, leveraged investing is not to be taken lightly, and should only be attempted by those who understand – and can bear – the risks involved. 

Margin maintenance

Going back and forth between paying off your loan and borrowing again to invest is impractical. Hence, in practice, leveraged investing allows you to maintain your position as long as the value of your collateral does not fall lower than your loan amount. 

This is known as margin maintenance, and in practical terms, this means you’ll need to be prepared to top up your account with fresh funds or asset when your margin is breached (known as a margin call).

If you are unable to top up your account, the assets held in your bank account – which, remember, is being held as collateral for your loan – will be sold off (or liquidated) to maintain your margin, and done so at favourable prices, further eroding your position.

Where are leveraged investments found?

By now, you have probably noticed that leveraged investing is not exactly suitable for the casual investor, but that doesn't stop it from being commonly found. 

You may find leveraged investing in:

• Priority or privilege banking. Wealthy individuals are often motivated to capitalise on their large investing capital through leverage, and may be better able to maintain a healthy margin. 
• Forex trading. Because the differences against currencies in a reading pair is small in real terms, leverage is commonly used to amplify trades without needing to put up a large capital.
• Stocks, indices and crypto. Investors trading stocks, shares, indices and cryptocurrencies can choose to do so using leverage, allowing them to amplify their positions for higher potential gains (and also losses, should the trade go badly).

Conclusion: Leverage is not for the faint hearted

Given the high risk-high-reward nature of leverage, it is just as well that school didn’t teach me how to make investments using loans. 

Clearly, leverage is not for the faint hearted. And neither is it for the reckless – although it might be a little strange given how the potential to amplify your gains is undoubtedly attractive to those who are a little too comfortable with risk. 

If you’re thinking of trying out leverage investing for yourself, be sure to use abundant caution, have clear targets and limits, and always make sure you have plenty of reserves to meet margin calls.

Read These Next:
The Pros And Cons Of Taking On Debt To Invest
Forex — How Investors Can Think About High-Risk Investments
4 Ways to Pay Off Credit Card Debt in Singapore
Personal Loans, Balance Transfers and Credit Lines: The Pros and Cons Rundown
This is How Much You Can Borrow From Different Loans in Singapore