The inspiration for this topic comes from a stellar comment that was left on my “How Much Money Would I Make If I Rented Out A House?” post. The commenter, Richard, laid out some great plans for how he was going to build his wealth empire. Essentially, he was going to borrow money to put together a real estate portfolio. This is the classic old mantra of using “other people’s money” to get rich, and it is certainly a path where a lot of people seem to have found great success.
Unfortunately I’m far too much of a weenie to invest in real estate (… yet). I prefer to invest in stocks and mutual funds because these are things I know and understand; a quality I think is very important before you engage in any sort of investment.
But quickly I see there is a big difference between my strategy and his:
When I want to buy stocks, I always need to put up 100% of the capital using my own money. Real estate investors, on the other hand, only need to put a relatively small portion of the cash. They just reach some minimum down payment level and then finance the rest.
So while taking the dog for a walk, this got me thinking about a great debate question for the readers:
Would You Borrow Money to Invest in Stocks?
How come the stock investors can’t get in on the action and use borrowed money for their investments too? After all: Isn’t real estate also considered an investment? So what’s the difference?
Technically the option is there if you really wanted to exercise it. One way is to buy stocks on a margin. That’s when you borrow a certain portion of the money from your stock broker to fund the purchase. The other way is to simply borrow money the old fashioned way – from the bank or another financial institution. This might be in the form of a home equity loan or some other similar finance option.
It’s one hundred percent recognizable that borrowing money to invest in stocks is risky, risky! It’s pretty easy to say “what if the stock goes down in price”? But who says you have to invest in ultra risky stocks? Why can’t you invest in ultra boring blue chip companies? Or what about gobbling up a nice variety of dividend paying stocks so that no matter what you get a guaranteed 3 to 4% yield (regardless of the share price)?
Real estate has made many people rich. But isn’t it also just as risky? Suppose you buy a rental property and it turns out to be lemon. Suppose no one rents from you for months. Suppose you do get tenants and they turn out to be an absolute nightmare! Your investment is looking about as good as Enron stock right now.
Readers – What do you think? Would you borrow money to invest in stocks? Or is this just a rotten terrible idea? Has anyone actually already done this and found success with it? Please feel free to share!
Related Posts:
- Which Is Better – Rental Income or a Stock Market Index Fund?
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- Should I Pay Off My Mortgage Early or Look for a Better Return?
Image courtesy of Vichaya Kiatying-Angsulee / FreeDigitalPhotos.net
We stay away from leverage and stocks, because the short term volatility possibilities make me too nervous. We have leveraged somewhat for real estate investing, but all of our real estate investments (outside of our primary home) will be paid off this year, which means that they were only leveraged for a period of 3 years.
Only 3 years to pay off your real estate properties? That’s pretty incredible! Either they must have been at a good price or you are just really determined to have them paid off.
Leverage and stock is a giant NO for me. Never, ever, ever.
Are you sure? You kind of sound like you are on the fence about this …
If margin is used wisely then it can be done to your advantage. That said, I have seen WAY too many people not use it wisely ad end up owing hundreds of thousands of dollars. Beyond that I would never borrow to buy a stock…just too much risk for me.
I think that right there is the trick: Knowing what it is that you’re doing. It’s one thing to buy a stock and get lucky. It’s quite another to be so sure about it that you take out some form of a loan in order to go all in.
You can borrow money to invest in stocks though a margin account. But the interest rates are very high and you run the risk of losing more in margin interest than you gain from stock appreciation and dividends. That doesn’t mean that using margin is a bad idea, but rather that it needs to be used very carefully.
Out of curiosity, how “high” are the interest rates? I’ve never looked into this …
This is something that I’ve thought about. I’ve taken whole classes on this topic and it is a tough decision. However, a little different with what I’m about to say, I know of someone who actually borrowed money from a bank and invested $20,000 in stocks. I’m not sure what he invested in, but from what I hear, he lost everything.
Something tells me that his stock pick was more a “bet” than an actual long term prospect or solid company.
Borrowing to invest in stocks? Sounds like madness.
It does. But if you compare it for a second to buying real estate such as rental properties or commercial properties, is there really much a difference?
yes, stock could go to zero, real estate is a physical asset which can be sold anytime.
Oh I did… big-time!
In 2009, after the market crashed, I borrowed every penny from my 401k (which was into money markets at the time) and maxed out our IRA contributions for two years with that, as well as invest “cold” (i.e. outside of IRA/401k tax protected vehicles).
And it paid off enormously. I spent a lot of time sniffing out stocks of good companies that were hammered in the crash. Most of those doubled within a year, a few even quadrupled. My only regret was not having enough money — I still lament not buying Royal Caribbean Cruise Lines at $6. Those are the types of bargains you only find in a recession.
But during 2010 I gradually unwound the stuff bought with debt. Even after paying income tax at ordinary rates, we still came out way ahead. By the end of 2010 we were out of debt completely. But our net worth more than doubled in that short time.
There is IMHO only one time to dive in with leverage, and that’s at or near the bottom of a market crash. You just can’t have enough cash for the bargains that abound then! It happens only once every 7-10 years, so I try to make it really count.
Nowadays, forget it, though.
Why did you choose to borrow against your 401(k) instead of just buying those stocks inside your 401(k)?
Now there is a blog post to read all about William! You’ll have to write up that whole story in detail and tell more.
I had a feeling that someone was going to say that the best time to do this was during a Recession, and in particular during the Great Recession that just passed. On the real estate side, I know that I will be kicking myself years from now when home prices go up and I’ll be paying 4x the price for a rental property that I could have swept up now.
I will highlight something you said: You spent a lot of time researching stocks! This is not the same as just buying what Smart Money told you buy or going on a hunch. I think there is a place for people to borrow and take advantage of stocks, but the successful ones will be the ones that know what they’re doing.
Did you borrow against your 401k because it was cheaper (at a lower interest rate) or because it was accessible?
Yeah, I could never do it. I’m not an incredibly huge risk-taker. William—your story is amazing, though! Congrats!
I’m not much of a risk taker either. That’s why I just wrote a post about it, sit back, and see what other people have done 🙂
I wouldn’t do it, but I can see where it might work. The volatility of the stock market is too much for me to borrow in order to invest. Yes, real estate is volatile, but its ups and downs are easier to predict as well as longer to run through. Interesting question though.
What’s funny is I always hear people taking about how there is so much stability in real estate. Yet houses and commercial buildings all across my area seem to sit empty for months and even years. This would be my biggest worry if I were ever to get into real estate; along with horrible tenants.
I won’t use it to purchase stocks outright, the interest is just way too high and I don’t want to have any debt. However, I do use a margin account to let me sell naked puts. This way I don’t have to hold the full cash to secure the put. I then adjust my cash in my account based on whether the puts are closer or further away from being executed. Pretty nice way to use “leverage” since I can collect the premium while I wait.
That is an interesting way to make your purchases. If I wasn’t using the strategy I’m using now, I would consider setting up a system like that.
I think it’s a terrible idea but I’m also doing it, kind of! I like the DR way of thinking that if you have any kind of debt and also investments, you have borrowed money to make that investment, even if that’s not directly how you intended it in the first place. Anyway, I have subsidized students loans that are in deferment and the savings we plan to use to pay them off are currently invested, mostly in stock funds. Yes, this could go very wrong, but we bought into lower-risk funds, we had a decent timeline (3 years ish), and we’re considering it a learning experience. I don’t think I would ever buy on margin, though.
In a round-about way, that is kind of true! In theory I could use my 401k to payoff my house. But of course I don’t because that’s not what it was intended for. So I can follow that logic.
Your student loan fund kind of sounds like my emergency fund. I too also invest in about as plain vanilla and safe of funds as you can get, thereby minimizing the chances that I’ll ever lose the full amount any time soon. It just kills me to leave any amount of money sitting around doing nothing productive when I could be getting a much better return; even if that money is ear-marked for something else.
If our house was paid off I’d take out a mortgage to buy property in certain parts of Macomb/Oakland county.
However, I don’t think I’d be willing to do it with stocks. It’s weird because both are investments and both have a chance of losing you money. But it seems that people, myself including, don’t want to use leverage for stocks.
My buddy just got a steal on a house over near St Clair Shores. It made me VERY jealous because I know that in a few years when I finally work up the courage to get some rental properties, I’ll probably be paying double what they cost now.
I’ve got that same fear. Although instead of getting over the fears I’ll finally be able to afford one, but the deals will likely be gone.
While the concept is similar, I don’t think I could ever borrow money for stocks. Houses I understand. I can pay an inspector to show me what needs to be fixed and I can pretty much know what I’m likely to get in rent. Some idiot could blow something up tomorrow and stocks are down to nothing. At least I have insurance on my houses if they blow up.
Interestingly enough, you can “buy insurance” for stocks as well in the form of options. Although it is a technique that I’m only vaguely familiar with, some of the more advanced stock investors use them to hedge their investments and protect themselves from losses. It’s a unique approach, but also one that can get very confusing to anyone who is not already accustomed to stock investing.
So true; just because you’re investing in tangible items such as property, doesn’t mean the risk factors are any less.
Exactly. Both are risky in my opinion.
I’m a big user of leverage when it comes to stocks. Always have been since I started investing. The only time I wouldn’t want to borrow to invest is in high inflationary times like during the early 90s when interest rates were double digits. Currently I have $50K of debt in my margin account and pay about $180 each month of interest. I think it’s worth it in the long run. Traditionally interest rates to borrow money for stocks has averaged around 7% or higher so the return isn’t worth the risk. Plus a lot of people borrow money to buy small cap speculative companies. But interest rates today are around 4% for a margin account (mine is 4.25% with TD bank’s brokerage), and by buying index funds or a diversified portfolio of strong dividend growth stocks I think the chance to come out on top over the long run is pretty good. Bernanke said he’s going to keep rates low until 2015 if not later so that’s why I’m comfortable holding 2.5 times my net worth in total debt right now 😀 But it’s not for everyone. I can ride the ups and down of the market. I don’t mind losing 40% of my investments on paper tomorrow because I don’t need the money right now anyway. But if I were getting closer to retirement or don’t like volatility then I wouldn’t do it. Mr. Buffett once said if you’re smart you shouldn’t need to use leverage, and if you’re dumb then you really shouldn’t be using it, haha 😀 And he’s absolutely right. Borrowing to invest is not something I need to do, but it’s something I can afford to do to increase my chance to become financially independent sooner, and that’s why I do it 😉
Excellent to hear! I was hoping that this debate wasn’t going to get too one-sided.
I’m glad you were able to share the interest rate because I think it makes the point I was trying to make within the post: You don’t have to invest risky or speculative. If the rate is low enough, you could simply just use the dividend income from slow growth value or index companies to payoff the interest on the debt and then enjoy the growth of the stocks at your leisure. This of course assumes you’ve got a long enough time horizon to ride out any cycles. And there will be cycles. As you mentioned, you’re comfortable losing assets if it comes to that because you do not “need” your money right at the moment.
The Warren Buffett quote is priceless. Thanks for sharing.
Technically we do because we have both retirement savings and a mortgage. We don’t leverage more than that.
Technically that is correct!
I would definitely NOT borrow money to invest in stocks. It just doesn’t make sense to me: if I don’t have it, I can’t invest it! Also, I don’t like being in debt. The potential money I could make isn’t worth the risk I would have to take!
I think a lot of people share your opinion. But now put yourself in a position where you and your husband were thinking about buying a house to use as a rental property. Would you borrow money for that? Isn’t that kind of the same as borrowing for stocks?
Hey MMD. It’s Richard, the poster whose comments sparked these questions.
MMD very thought provoking topic–I truly enjoy your blog.
I look at these two options (leveraging for real estate and leveraging for stocks/bonds) a bit differently based on my comfort level.
My stock/bond portfolio is invested passively with various index funds. I am not trying to hit a home-run with my returns. I try to beat inflation and gain a little extra for the risks of investing in the stock market. After expenses/taxes, I am happy with a 3-5% after inflation return on my stock/bond portfolio. I’m in a stable job, and returns like these will get me where I want to go. I’m not too aggressive with this area of my investments. So far it’s been working well. I don’t need to leverage my stock purchases to achieve these goals.
With real estate, I would purchase properties with leverage. I can run the numbers and reasonably tell if cashflow from the properties will cover the payments I need to make to pay back the money I’ve borrowed plus expenses. These types of calculations are not as easy for me to do with a stock/bond portfolio given my skill set. Yes, there will be times that I may not have the number of renters I want (I talk about how I would cover this risk below). Also, I may have additional repair expenses that I hadn’t calculated into my rental budgets, but many of these costs can be covered with insurance/home warranties.
Also, If I treat my “safe” cash reserves in CD’s, treasuries, etc. as the “bond” portion of my real estate portfolio (my goal is to maintain safe reserves to offset the amounts of the mortgages that I have outstanding), then I feel I can weather even serious spans of decreased rents or increased repair costs. With real estate prices depressed right now, I don’t feel like there is as much risk of further drastic property depreciation presently. I know it can happen. However, if properties are bought with a discount by motivated sellers or foreclosures, I build in protection from depreciation. The rental income I am able to garner will also build equity into these properties with other people’s money that will also decrease my downside risks. The tax benefits of depreciation (and other tax benefits) add even more protection. These tax benefits occur even if my properties gain in value (unlike my stock/bond portfolio). I can always pay off the mortgage with my bond-like reserves to drastically decrease the cashflow requirements of these properties and hold on to them until whatever time I would like to offload them if need be. More than likely I would only need to use my safe reserves to cover the monthly mortgage/expense payments (I wouldn’t have to payoff the mortgage and deplete my safety reserves all at once). Therefore, the “need” to offload these properties at a particular time will be very reduced. That may not be true with a margin call on stocks.
I really look forward to the dividends rental properties pay out via cashflow (especially after the properties are paid off) if all goes as planned. Heck, even if the properties themselves become completely worthless, as long as I have renters providing me cashflow, I’m still doing OK–it’s hard to say that about stocks/bonds. The main downside would be if I had very few renters AND drastic property depreciation. In this situation, I could always try to sell the properties. I would hopefully get a good portion of my initial investment back. And, as stated above, I likely would have protected myself somewhat by paying a lower than market price for the home and with the equity I hopefully would have built up via prior rental income.
With a stock/bond portfolio, I would rely on the 3-5% real appreciation of my current portfolio as well as the truly small dividends that my current portfolio provides to protect me from downside risk. I guess trying to keep these scenarios similar, I could have “safe” investments in CD’s/treasuries/etc to cover the leverage that I used to purchase the additional stocks/bonds, but the volatility of the stock market makes me more nervous than with real estate as to the swings a stock/bond portfolio can take compared to long term real estate markets. Also, I’m not a market timer when it comes to purchasing stocks/bonds. I make purchases every month and rebalance as needed. With real estate, I feel much more comfortable being a “market timer.” That’s just me. I guess, right or wrong, I feel more in control of my exit strategies with leveraged real estate as compared to leveraged stocks/bonds.
I know there are plenty of holes in my assumptions, but at some point you have to put your faith somewhere. You can have faith that the stock market will continue to climb over the long term (I’m not considering shorting, etc.). You can have faith that you will be able to find renters to produce long term cashflow with enough properties under your belt. Your “faith” will be largely influenced by your given skill set and knowledge of a particular mode of investing.
I think in the end it comes down to what you are comfortable with and what you feel you can best manage. For me, it’s passive investing with stocks/bonds and managing the risks of a real estate portfolio that appeals to me. Others will feel the complete opposite, and I think that’s fine too. We are all trying to do the same thing in the end–provide a financial footing to live our lives the best way we know how.
Thanks again for inspiring this post Richard.
I really like the design you have set forth for your rental income ambitions and using your cash reserves to act as a small insurance policy in case things go wrong. I think that is a smart way to play this game, and probably where a lot of people misstep when it comes to being a landlord.
It’s interesting that you bring up not being concerned with making money on the properties themselves. Couldn’t the same be said for a high quality stock? For example, say you had a blue chip company stock paying a 4% dividend (say $1 per share). You were able to borrow money at 2% and use that money to buy shares of that stock. Essentially, for as long as you hold those shares and the company remains profitable, you’d collect a net 2%. Even in the event that stock price went down, as long as the company continues to maintain that $1 dividend payment (which many Dividend Aristocrat stocks do regardless of their share price), you’d still be okay. You’d just have to ride out the long term until the share price picked back up again. (Of course this wild example would require a lot of finesse when it comes to inflation, loan payback terms, the loan interest rate, which stocks you pick, etc.)
I’m curious: On the real estate front, do you think you would ever amplify this model to something more high-stakes such as an apartment complex or commercial building (if you had the cash reserves to do it)? It would be the same principles of using other people’s money to fund the project, but it would have considerably much higher pay off as far as dividends
I’ve asked this question many times as a hypothetical. It seems like if you’re borrowing for the long term and investing for the long term, it’d most likely work out. That being said, I don’t think we’ll see too many people do it with the market at all time highs.
You are probably right. However, how do we know when we are at an all time high? A month from now the Dow could be another 1,000 points higher, and we’d be looking back saying I wish we had invested when we had the chance in April.
I would. And I did a few years ago. I took out a 0% APR “balance transfer” (with a 3% fee) where I had cash transferred to my brokerage account. I then acquired stock and sold covered calls on the stock and made out decently.
That’s very interesting! No joke; I’ve considered doing the same thing when I get those spammy junk mail ads offering 0% APR. I suppose at some point I should sit down and do the math to see what exactly my risk would be for actually doing it one time.
Stocks are a kind of investment with higher yield but with high risk at the same time. If you know the movement of the market then it is worth the time in borrowing and investing in stocks. The timing is to buy low and sell high. You need to do lots of research before placing your money in a particular stock to gain more. This kind of venture is a long term process. It would be great to redeem the investment after 5-10 years or even more to maximize the profit. No pain no gain still consider other options in growing your money and do not rely on a particular investment portfolio only.
If only we knew the timing of market … That would make things a lot easier and give me a lot more confidence that I wasn’t going to lose my principal investment!
I don’t think that would be such a good idea unless you knew 100% how that stock was going to do. Borrowing money to invest has always been a big no no for me and I would advise the same to others.
I don’t think anyone ever knows 100% about any investment before they jump in. I would argue that this is especially true in not just stocks but real estate as well.
I think leveraging for stocks is a great idea and do it. Like you keep stressing, the importance is making smart and calculated long term investments, NOT speculative bets. All of those horror stories that people love to rant about where “they lost it all” revolve around people treating the stock market like a casino. As an investor you need to be responsible.
I don’t know if you live in the US or Canada, but here in Canada our mortgages aren’t tax deductible. However, when using something called the Smith Maneuver, you are able to use a home equity line of credit to borrow against your house to invest with and then use this investment interest as a tax deduction. This is what I do. I am able to convert a portion of my non deductible mortgage (bad debt) into an invest loan tax deduction, while at the same time I’m technically leveraging my stock investments. I play it very conservative and buy boring large cap blue chips that are Buffet worthy.
I am growing my net worth at an accelerated pace while getting a massive tax refund every year (which I then apply back onto my home equity line. And repeat the process). I will have my mortgage “paid off” very quickly (and by paid off I mean converted into good, tax deductible debt). At some point I will deleverage by paying down my good debt. I can do that by either paying down my debt like a person normally would each month or by selling a portion of my investments. In the mean time I get those beautiful tax refunds and the power of compounding leverage behind me.
Before the dooms day nay-sayers begin… I’ll state that I am never looking to hit the jackpot with any of my stock purchases. Again, I am buying very boring blue chip, Buffet worthy stocks with a loooong term position in mind. I’m sure everyone has seen a picture of any North American stock market index over the last 100 years. You know the one? With that gradual sloping line that goes upwards to the right 😉
Ah, finally another advocate for “yes”!
Great comment! I live in the US, so I do get the benefit of having a tax deductible mortgage. This is a very interesting strategy that you are using to tap into your equity. The only thing that makes me somewhat nervous is using your house as collateral for the loan. Of course, if you ever did default on a loan, I’m sure they could go after your home anyways.
I’m glad you highlighted one very subtle point I made in this post that I don’t think a lot of people picked up on: Investing in solid companies, not making wild bets. A lot of people think they are really putting themselves out there if they buy stocks. Maybe in the short term you might. But I agree – look at any 20 year period of the stock market and you’ll notice a trend – an upward trend! If you invest in boring solid companies, you can reduce your risk and capture some of the most efficient returns out there.
To be perfectly honest on my way to financial independence I would borrow any money to buy stocks. I would only invest money in stocks which I do not need for the next 5-10 years.
I invested in real estate and describe my investments quite explicitly and openly. Normally it brings 1-3% annually. Albeit on one occasion it was 9%.
A colleague of mine borrow $30K to invest in stocks and he lost them in a week time. I would not do it.
I might be going out on a limb, but I’d bet that $30K your colleague borrowed wasn’t in what I’m calling “boring, safe” investments. If he had invested $30K in a pool of profitable dividend companies, I’m sure he’d be telling quite a different story.
Now is a great time to borrow money to buy stocks because the Fed has made money cheap.
Six years ago, short term interest rates were about 5% and low quality corporate debt was yielding, say, 6-10%. If you borrowed money then, you could get a spread of perhaps 2 or 3 percent.
Today, you can still buy that corporate debt, but you can borrow money on margin for about 1% because of low short term rates.
Investors are often complaining about earning no interest on their cash. But, this low interest rate environment actually makes it easier earn MORE interest if you are willing to buy the right kind of debt and use margin.
This is by far the easiest way I make money investing. The way I see it, short term rates could gradually rise back to 5% and I would still earn a spread. But, it could be 5-10 years before that happens!
I’m very curious: Who is offering to let you borrow on margin at 1%? I’m half tempted to look into it further …