Taking a Loan to Invest in Stocks Is a Bad Idea

You invest Rs 50,000 in stock market. Your investment doubles in 6 months. A 100% gain in 6 months is a reason to rejoice but something pinches you. Even though you made a 100% gain, it is not a big amount in absolute terms. Wish you had invested a bigger amount. You would have earned greater absolute returns. After doubling your investment in 6 months, your confidence in your investment acumen is likely to be sky-high. More so if you are a new investor and have not experienced market cycles. All you need is more money and the profits will follow.

How do you manage more money to invest?

  1. Borrow/take money from family/friends/parents
  2. Take a personal loan from a financial institution

Editor’s Note: It is not uncommon for folks who have prepaid a big chunk of their home loan to get a pre-approved top-up loan offer from their bank. Many banks tout the lower interest rates, tax benefits and also let you use these funds for any purpose. You are an existing creditworthy customer and this makes it safe for your bank to offer top-up loan for up to the original sanction amount. Given that the markets have fallen significantly recently, it may be tempting for you to use these funds for investment. However, its important to remember the pitfalls of investing borrowed money. You could lose your job and your home in these troubled times.

Everything will be hunky-dory if you continue to earn good returns. However, no matter how good an investor you are, there is no guarantee of good returns. If you are really a good investor, only the odds of success improve over the long term. Over the short term, anything is possible. And when you borrow for investing, the borrowing is likely to be for the short term or perhaps even callable. When your friend/relative says he needs his money back, you can’t say, “please come after 6 months”.

What if you incur losses? When you lose your money, you can’t lose more than what you have. When lose borrowed money, you can lose more than you have. The idea of investing borrowed money was to earn higher absolute returns. However, this can also result in greater absolute losses. That is the flipside of using leverage in investing. This can lead to serious mental and financial stress. If you can’t return money on time, it can also jeopardize your relationship.

If you are borrowing from your parents, you may feel less pressure. However, remember your parents’ retirement money is not investment project.

What about Personal Loans?

Most of the points about borrowing from friends/family/parents apply to taking a personal loan to invest too. However, there are a few differences. First, let’s talk about the benefits.

A personal loan will be more structured. You know upfront that you just have to keep paying EMIs and no one will ask for the money. If you can pay off the EMI from your regular income (and not rely on income generated from investments), then the pressure will be low.

On the negative front, a personal loan will be much more expensive. While your friend or a family member may lend at zero or nominal interest, you will have to pay market rate for a personal loan. And the interest rate can range from 10% p.a. to 30% p.a., depending upon your credit profile. There will be processing fee and other charges too that will add to the cost.

For this entire exercise to be meaningful, you must earn a return that is higher than the cost of the loan. And the cost of the loan is not just the rate of interest. If you have earned 10% on your investments while the loan costs you 15%, then you have lost money on your investments.

If the loan costs you 15% p.a., you must earn more than 15% per annum.  Moreover, you must earn this (more than) 15% p.a. return during the loan tenure (and not over the long term). To justify the risk taken, you must earn much more. You can say that you can refinance the loan at regular intervals but that has its own set of problems. What if you can’t refinance for any reason? To make matters worse, what if your investments are also trading low at the time or can’t be exited? Just because you have taken a loan, the markets may not be in the mood to reward you. The markets can go through a bad phase during the tenure of the loan.

Repay Loan from the Investment

If you must rely on income from investments to repay the loan, then you have an even bigger problem. Your investment may go through ups and downs, you are fine if it eventually recovers and gives you the desired returns. However, if you rely on income from this investment to pay off the loan, then you will have to sell shares/MF units to repay the loan on a regular basis. When you sell a share at a low price, your loss becomes permanent. The stock may recover later but your portfolio may not because you sold the shares.

Let’s consider an example. You borrow Rs 10 lacs and buy 1000 shares of a company at Rs 1,000 per share. You must pay Rs 20,000 as the EMI for the next 70 months.

At the end of the 1st month, let’s say the stock price is Rs 1,000. You will have to sell 20 units to pay the EMI. Remaining balance: 980 shares

At the end of the 2nd month, the stock price is Rs 800. You must sell 25 stocks. Remaining balance: 955 stocks

Let’s say this continues for the next 4 months. At the end of 5 months, you will have 855 stocks.

The price further falls to Rs 670 and stays there for further 6 months. You will have to sell 30 shares per month. Therefore, at the end of 1 year, you will have only 675 shares.

Now, let’s say the price suddenly recovers to Rs 1,200 (20% from your initial purchase level).

Value of your portfolio will be Rs 675 X 1200= Rs 8.1 lacs. Total outstanding value of the loan will be Rs 8.73 lacs.

As you can see, while the stock price is 20% higher from your purchase price and the loan interest rate is only 12%, your portfolio value is not sufficient to square off the loan. This happens because, by selling shares at a lower price at a lower price, you made your losses permanent. While the stock recovered, your portfolio didn’t get the full benefit. You might argue that I have chosen the example to suit my argument. Yes, that’s right but worse things can happen in the markets.

The Need for Action

Another problem with taking a loan to invest is that you will always feel the need for action. After all, you are paying a high rate of interest for this loan. You can just let money lie in your bank account and earn 4% p.a. This can lead to even greater mistakes. You might take unnecessary risk that can backfire. As I mentioned earlier, you can’t just manufacture opportunities in stock markets. During bad times, even good stocks will struggle on an absolute basis. And in your case, absolute returns matter because you must pay absolute costs to your bank.

In my opinion, taking a loan to invest in stock markets is not a good idea. The lowest cost of a personal loan will be 10-12% p.a. You must earn much more from your investments to justify the risk taken. And that’s not easy for most investors. Many investors try this (borrow money) to make quick listing gains in an IPO. It does not always work. Even HNIs struggle to make money in IPOs using leverage on a consistent basis.

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