February 5, 2023

Reasonable or Risky? Should You Take Out a Personal Loan to Invest?

If you think you’ve spotted an exciting investment opportunity, you might be tempted to take out a personal loan to jump on it. But you should resist the urge.

A personal loan is a lump sum that borrowers pay off over a set period, usually with a fixed interest rate. Whether you’re considering investing in the stock market, a business venture or something else, carefully think through the risk.

“Risk is awesome on the upside, but extremely painful on the downside,” says Diane Hirschhorn, lecturer of finance in the Leeds School of Business at the University of Colorado Boulder.

Why Shouldn’t You Use a Personal Loan to Invest?

There are several ways in which taking out a personal loan to invest can come back to haunt you. Reasons to reconsider this choice include the following:

Your Lender Might Not Allow It.

Lenders such as SoFi and LightStream explicitly ban borrowers from using their personal loans to purchase securities such as stocks. Lenders also often prohibit using personal loan funds for business expenses, according to the credit bureau Experian. If you use the loan incorrectly, you may have to repay it all at once, including its interest.

You Stand to Lose Too Much.

You should carefully consider what you stand to lose if your investment doesn’t pan out. When you take out a loan, “you’re taking on a fixed obligation for a speculative return,” says George Gagliardi, certified financial planner and founder of Coromandel Wealth Management.

You know you’ll have to pay back the loan at a certain rate, but you are not guaranteed a positive return on your investment. To make money on your investment, you’ll need it to ultimately have a rate of return that is higher than your loan’s interest rate.

“I would look at this range of possible returns, and I’d really be interested in the downside risk, not so much the upside,” Hirschhorn says. “Because on the upside, we live happily ever after, and the downside is when things don’t work out, what happens to me. What is my downside exposure, what happens to me personally.”

You should also think about how you would handle an unexpected event such as a job loss or medical emergency when determining whether the risk is worth it. “I don’t think any investment is worth taking unless you can absorb the loss (and) are willing to lose all of it or whatever fraction you’re putting at risk,” Hirschhorn says.

You Should Focus on Other Financial Goals.

There are plenty of ways to improve your financial situation that don’t come with the risks of investing money from a personal loan.

Paying off existing high-interest debt, for example, comes with a guaranteed return. Say you have debt on a credit card with a 25% annual percentage rate. “That’s a guaranteed return of 25% a year. You can’t get that on the market.” Gagliardi says. “To me, that’s the smartest investment.”

And if you have time, you can make money on the stock market even if you don’t have a lot of funds when you start. “It doesn’t really take that much money if you have lots of time,” Hirschhorn says. “Just start early, be methodical and in fact embrace the market going down because you’re buying stocks at a cheaper price.”

When Can You Consider Using a Personal Loan to Invest?

If you’re still interested in using a personal loan to invest, consider these questions to further evaluate the situation.

Is the Investment Low Risk?

If your investment has a guaranteed return, like I bonds do, it could be worth considering. “Anytime that there is a guaranteed rate of return for the length of time of my loan that is greater than the cost of my loan, that’s a good economic trade,” Hirschhorn says. “But unfortunately those situations are very unlikely and unusual.”

Investing in your education with the help of personal loan funds can make sense under the right circumstances. Be sure to do the math, considering factors such as your expected salary and the opportunity cost of lost work.

Someone training to be a doctor, for example, may decide this is a good trade after doing the math, Hirschhorn says. In contrast, if giving up two years of work to get a master’s degree in education would only increase your salary by a small amount, it probably doesn’t make sense to borrow.

Another question to consider before borrowing is how much control you have over the investment. “If it’s an investment in you and your business, that’s one thing. It’s completely different than turning it over to a financial advisor or turning it over to a third party to run that money,” says Ralph Bender, CFP and founder of Enduring Wealth Advisors.

Are You Getting the Lowest Possible Rate?

If you’ve decided to take out a personal loan for investing, you should at least make sure you’re getting as low an interest rate as you can. Doing so will help you minimize the cost of your loan and get the most out of your investment.

“Price comparing the loans would be very important because it’s going to enable you to have a greater spread in return on your investment,” Hirschhorn says.

Are There Other Borrowing Options to Consider?

Depending on your resources and how you plan to use the funds, you may be able to consider alternative options.

Traditional 401(k)s or traditional individual retirement accounts involve borrowing money from the government, Hirschhorn says. This is because you don’t pay taxes upfront, unlike with a Roth retirement account. “That’s actually a pretty good trade,” she says. “Because the reason why you’re choosing a traditional over a Roth is because you expect your tax rate will be lower when you retire.”

No matter what form of borrowing or investing you are considering, make sure you understand the risks before jumping in.

Source link