Borrow to invest: the theory about it, not the wisdom...

grandplonker

I've been trying to clear in my head how interest works if you borrow to invest.

I understand it's high risk - I'll talk about that bit another day.

Supposing I invest £1,000 for a year, in monthly installments, and it gets 10%. I've only made £50, not £100, because the average balance for the year is only £500.

Supposing I take out a 12 month loan for £1,000 and invest it as a lumpsum for a year. The loan is 5% and the investment is 10%. That £1,000 investment makes me £100 interest, because the average balance for the whole year is £1,000. Interest on the loan costs £50. Subtract that from my investment profit, I've still only made £50.

ie, If I'm going to borrow to invest, my investment interest has to be twice the loan interest (one reason it's high risk) or there isn't any point. I might as well have not taken out the loan and did it normally.

Supposing I split it half and half. I invest £500 for a year, monthly installments, and make £25. I also borrow £500, earn £50 profit, pay the lender £25 in interest leaving me £25 richer from the invested loan's interest. I'm still only £50 up.

Does my maths add up? So long as the investment interest is double the loan interest, it doesn't matter whether I have a loan or in what proportions?

I'll probably not get a personal loan at 5% (correctly used credit cards are better), investments at 10% I might not find either, investments can fall and leave me in negative equity, you don't just invest for a year, etc. I understand real life isn't like that, I'm just trying to get my head round it all. Please don't judge me on that bit.

Archi_Bald

It's a bit of a no brainer that if you pay out less than you take in, you will be left with a surplus. If investing was that easy, everyone would do it this way.

bigadaj

You aren't comparing like with like though. You're drip feeding the invested money rather than investing as a lump sum, but obviously borrowing the money as a lump sum.

Gearing and investment will exacerbate the returns, whether they are positive or negative, as if you are investing the money it could easily fall rather than increase.

jimjames

grandplonker wrote: »

Does my maths add up? So long as the investment interest is double the loan interest, it doesn't matter whether I have a loan or in what proportions?

If you pay less out than you've earnt from investments then yes it does add up.

However investments don't tend to pay interest - you have capital and dividends both of which contribute to the return and the capital may drop below the loan amount so you'd be in a loss.

What you are suggesting isn't crazy, many investment trusts use gearing to potentially improve returns by borrowing at a lower rate than they aim to achieve on the investments.

grandplonker

Every time I buy a new fund, my dealer (HL) offers me accumulation or
regular income. Whether a 10% return means £100 in my bank or the fund being worth £1,100 after a year, to refer to it as 'interest' is good enough for now.

Without leverage now, I invest monthly. If I took out a loan I would buy investments immediately. I consider my scenario accurate on this part, too because it compares my real life now to what I would be doing.

guymo

grandplonker wrote: »

Supposing I invest £1,000 for a year, in monthly installments, and it gets 10%. I've only made £50, not £100, because the average balance for the year is only £500.

Supposing I take out a 12 month loan for £1,000 and invest it as a lumpsum for a year. The loan is 5% and the investment is 10%. That £1,000 investment makes me £100 interest, because the average balance for the whole year is £1,000. Interest on the loan costs £50. Subtract that from my investment profit, I've still only made £50.

Don't forget that in the loan/invest scenario you've also got your £83.33 monthly money kicking around that you can do something with...

bowlhead99

guymo wrote: »

Don't forget that in the loan/invest scenario you've also got your £83.33 monthly money kicking around that you can do something with...

Exactly. I think OP may be missing something.

Effectively, he has shown that if he has access to surplus money from a job or other income, he can build up a pot of £1k with £50 profit returned at the end of the year, having a total asset value of £1050 with £1000 "owed" to the savings account or piggy bank that he would otherwise have put the £83.33 a month into.

Alternatively, he thinks, he could take somebody else's money, invest it at a margin of 5% over the 5% borrowing cost, then pay back the loan and be left with £50. In one sense it is the same £50 return. And he owes somebody (whether the bank, or his own savings pot), £1000 at the end of the year.

Put that way, it sounds like either way you only get £50 so why borrow and risk owing someone £1000 if/when the investments fail.

The answer of course is that if you have the requisite £83.33 a month for your own investment, and also have the status/ creditworthiness to support borrowing, you can go ahead and make £50 a year off it and also make £50 off the borrowed money for a total return of £100.

Looking at the returns:
1)Invest from income, unleveraged?
£50 from average committed cash £500 is 10%.

2)Invest someone else's investment with zero of your own money down?
£100 less borrowing cost £50 =£50 returned from your average committed cash £0 is infinity %. This is literally free money on top of whatever you make with your own money; you could borrow a billion and get even more free net income; the only cost is the potential downside risk if the investment doesn't work out as hoped.

3)Invest from income (average 500)and borrowing(1000)?
£50+50=100 from average committed cash £500 is 20%

This would lead you to borrow as much as you can to invest. #3 is double the return of #1. However, risk is heightened; what if the returns were an unlucky 2% instead of an optimistic 10%? Then it would be:

4) Invest from income, unleveraged?
£10 from average committed cash £500 is 2%.

5) Invest someone else's £1000 at 5% cost with zero of your own money down?
£20 less £50 interest expense = -£30, from average committed cash zero = negative infinity %. You owe the bank infinity times your zero stake.

6) Invest from income (average £500) and borrowing(ave 1000)?
£20 plus £20 less £50 interest expense = -£10, from average committed cash £500, is -1%.

So by leveraging, if the returns don't beat your interest cost in a less positive return environment, you can obviously lose. What if returns were not even positive, say negative 10% instead of positive 10%?

7) Invest from income, unleveraged?
£-50 from average committed cash £500 is -10%.

8) Invest someone else's £1000 at 5% cost with zero of your own money down?

£-100 less £50 interest expense = -£150, from average committed cash zero = negative infinity %. You owe the bank infinity times your zero stake. A bit like scenario #5 above. But paying off this disaster will take a lot longer than #5 above. You lost 5x as much as when the returns were 12% better (i.e. when they were +2% vs -10%. Clearly the gearing idea is fraught with risk.

9) Invest from income(ave 500 balance) and borrowing(ave 1000)?
£50 loss on your investment from income/savings and £100 loss on the borrowed investment, less £50 interest expense = -200 "return", from average committed cash £500, is -40%.

Does that make sense Grandplonker?

Does my maths add up? So long as the investment interest is double the loan interest, it doesn't matter whether I have a loan or in what proportions?

Well: consider a 100% return and a 50% borrowing cost.

If you invest £1000 of borrowed money for a year you get £1000 income less £500 interest expense. This could be compared to investing an average £500 balance from your savings at 100% return to give £500 income. So yes, maths still works.

But the reason that it "works" is simply that if you invest twice as much money (average balance in the investment of £1000 over the year, rather than £500 when drip fed), but you only keep half the profit (because borrowing costs are exactly half the investment return), you will get to the same place. If/when borrowing costs are not exactly half the investment return, you will get to a different place.

So the coincidence that being invested twice as much but losing half the returns to costs, gives the same net profit as being invested half as much and paying no costs, doesn't tell you anything about whether you should borrow, because

i) the investment return is not guaranteed unless it's fixed savings account;
ii) you havent considered 'opportunity costs', i.e. what would you do with the average £500 you could have invested from income/savings if you are not investing it in this scheme.

In reality, the return will always be something other than exactly double the borrowing costs because it is unpredictable. So you will get a whole range of returns as per the examples in 1-9 above.

A side note just to be picky: if you're dripfeeding you might have £83.33 invested twelve months, another 83.33 for 11 months etc down to December's contributions which only have 1 month. This gives you a bit more than 500 invested on average because you already have £500 in the pot by 1 June (i.e. before the halfway point of the year). However, alternatively if you are investing at the end of each month after you saved up for it, the first contribution is only at work for 11 full months, and the last contribution at 31 December will top up your investment to £1000 on the last day but it won't produce any return. So this is a bit less than the return you get by putting in £500 on day one and leaving it.

In other words, depending on exactly how you deploy the cash, you might find that dripping £1000 in over the year gives different returns to the result of investing £500 fixed for a year, or £1000 for the year with half the returns paid as borrowing costs. You can manipulate the dates to get the 'right' result though, so doesn't really change the main points abaove.

grandplonker

Bowlhead let me know if you write any books about investment. (That's a compliment.)

There's a little confusion here. Two scenarios:

1, No Leverage: I invest £83.33 every month for a year. No loans. Total invested is £1,000. Total profit: £50.

2, 100% leverage: I borrow £1,000 in January and invest all of it straightaway. I pay it off at £83.33. By January the next year, I owe nothing on the loan, I've made £100, and paid £50 interest to the lender. I've still only made £50.

To clarify, I'm paying the loan off monthly, not in a lumpsum after the year. I would not in fact have a spare £83.33 a month.

So, the my basic theory is right. Assuming loans are 5% and investments are 10%, it doesn't matter whether I invest via a loan or not. To make borrowing to invest worthwhile, I would need to borrow at 4% and invest at 12%, for example.

That way, I would make £120 profit and pay £40 borrowing interest, having made £20 more than investing it normally.

Glen_Clark

grandplonker wrote: »

Assuming loans are 5% and investments are 10%

a dangerous assumption...

bigadaj

I'm sure bowlheads book would be very good, but if it were only fairly successful then the amazon rainforest might be put in jeopardy with the amount of paper that might need to be used?

Glen_Clark

Borrowing to invest is all very well for investment managers (they call it 'leverage')
They can borrow more cheaply than you. More importantly they are not gambling with their own money. If their gamble wins they get a bonus. If their gamble loses somebody else takes their loss.
They can't lose - you can because you are gambling with your own money!!