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

bowlhead99

grandplonker wrote: »

To clarify, I'm paying the loan off monthly, not in a lumpsum after the year.

OK so to clarify, what you are saying is that you have a monthly incoming cashflow available, say from a job or other regular-paying investments or savings, and you have the choice of:

(a) waiting until your income arrives and then adding to your investment each month (building up to 1000 by the end of the year) ; or

(b) borrowing and investing immediately, and as your income arrives you use it to pay off the loan (knocking it down to 0 by the end of the year)

If that is the case (and using your basic maths rather than looking at the exact timing of monthly cashflows) we could say:

in model (a) you have on average 500 invested and it gets you 10% return so you get 50 income

in model (b) you have on average 1000 invested and it gets you 10% return so you get 100 income

in model (b) your way of looking at it, you have to pay 5% interest expense, so on 1000 you pay 50. The net of the 100 income and the 50 expense is 50 profit, same as in method (a).

HOWEVER

in model (b) you don't actually pay interest on 1000 @ 5% = 50.

You said you were going to pay the loan off monthly, right? Well if your borrowing is declining from 1000 on day 1 to 0 at day 365 through paying off monthly lumps, you should be using the exact same logic as you used yourself on the investment side in model (a) when you said that the average balance actually invested was only 500 because it moved from 0 to 1000 over a year. In this case your average amount owed is only 500 because it moved from 1000 to 0 over a year.

So you are earning 10% on 1000, the money is deployed into the investment all the way from day 1 to day 365. But you are being charged 5% on only 500, because the money your creditor has at risk is declining all the time from 1000 on day 1 to zero day 365.

Consequently the correct (simplified) maths for model (b) is that you have income of 100 [average invested 1000@10%], while you have expenses of 25 [average borrowed 500@5%]. Total profit is 75 which is more than you would have got by investing only your own money as it became available.

Intuitively this must be correct (at least the direction of performance if not the exact figures), because:

By borrowing, you had cash immediately out there fully invested in January, and it kept earning you money all year. If you had been building up the investment as the cash became available you would have only got half a year's money invested on average. Or a different way of looking at it is that on average your money would have got into the investment half a year later. However you prefer to view it.

But effectively your investment is only half as good as it could have been if you'd had money out there fully invested in January. We should be able to double that performance by having someone else front the money for us and get fully invested in January, 6 months earlier.

Of course, there is a cost associated with getting the money 6 months earlier. But it is not a cost that lasts a year. It only lasts as long as you owe the money. Which is 6 months, the amount of time it takes you to pay it down using the money that comes from other sources, that you would have been dripping into the investment in model (a). I mean some of it doesn't get paid down until month 12, but then some of it got paid off in month 1, so on average it gets paid off in half a year.

One way of looking at it, to understand where the extra profit came from, is to say:

Base case (a), I earn 50 quid by having my money invested in a profitable asset for on average half a year.

Leveraged case (b), I am going to get someone else's money invested first, so I can get 6 months more income. I know 6 months' income is 50 quid so my income would double from 50 to 100 by doing this? Ah OK, but what does it cost me to borrow the cash for 6 months? Well, if it costs me as much to borrow the cash in those 6 months as I can earn on the investment in 6 months (i.e. the interest rates are the exact same), I will be break even and there is probably no point. BUT actually I don't have to borrow at 10%, I can in fact borrow at only 5% APR! So clearly I am going to profit from that.

If I can use someone else's cash to make an investment in those early 6 months (that I couldn't have otherwise afforded), AND they don't want to charge me as much as I make on the investment (that I wouldn't have otherwise been able to make), it has to be a winner. It has to be worthwhile borrowing at 5% or 6% or 8 or 9 or even 9.9% if I can get 10% in the door during the period when I wouldn't have otherwise had the investment, if I can keep the difference for myself.

In the real world of course one of the reasons you might not be able to keep all the difference for yourself is due to tax. For example if you borrow to fund an ISA or other tax-free investment and it gets you 10% return and it cost you 7% to borrow, you have made clear profit; all that's stopping you is the fear that it might not return 7%+ and then you would be a loser. But if you are a risk taker, go ahead and fill your boots, as much as you dare.

However if your investment is not in an ISA and you are a taxpayer, that 10% gross return is knocked down to some smaller net return depending on your marginal rate, whether you need to pay income tax or capital gains tax etc. It's possible to be in a situation where your return beats your borrowing cost, but then you pay tax on the return giving a lower net return which does not beat your borrowing cost.

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.

Sorry, but that basic theory is not right. If you want to make an investment at 10% and someone will give you the money to make it and they only want 5% back, that is money for nothing (ignoring risk of ruin when the investment falls over). From a pure returns point of view it has to be better to take that loan and invest more money or invest the same money for longer, in the lucrative investment opportunity.

Of course as you outlined in your first post that's just maths rather than a recommendation to actually borrow to invest.

Logically speaking the reason you can borrow money at 5% is because the lender views you as a low risk either because their loan is secured, or they think you would have no problem paying back, or perhaps you would have a problem paying back but you will still prefer to pay back rather than go bankrupt and you as a single individual human will be easy to chase through the courts and they will get their money plus interest plus debt collectors' fees.

While if the investment opportunity is offering 10% potential there is a risk that it is not at all safe and [some] years out of 10 you will lose some of the touted 10% return, if not a large chunk of the principal.

Hope this helps. No book is available but feel free to print out my old posts and send me royalties at your discretion. You might want to print full duplex two pages per sheet

grandplonker

Excellent point.

The missing word here is APR, which was as transformational to loans as the tube would have been in Ancient Rome. Gold standard for easy comparison.

You're backed up by this calcluator which says 5% loan interest only means £26.68 in total interest for the year. (The extra £1.68 is I think compound interest.)

So, the option b leveraging would increase my profit to £73.32 (after £26.68 in loan interest). That's £23.32 more than the option A no-loan investment.

Likewise if the investment return was 7.5%, I would make £48.32 after loan interest. That's £1.68 less than I would have made in the no-loan investment.

Therefore the 'profit threshold' must be an investment return 1.5 times the loan interest, approximately? That means that if my investments are making 15% then a loan at 10% or less will increase the profit?

Prothet_of_Doom

An IFA freind of mine, uses the word leverage.

If you have £10K you can borrow £100K, and provided the £100K makes more money than it costs you've made more.

Classic is BTL's £40K down, £60K borrowed, at 6% (£3600). Rent is £7K a year, house capital increase could be +/- 10%. (lets say 5%)

So Each year that £40K makes £8400

So on the £40K you make 21% ....Not risk free by any means.
If you borrowed the £40K in the first place of your parents, and gave them 5% (i.e £2K ....double what they might have got in the bank) you've made a stonking £6400 with zero investment.

Why ain't we all doing it?

grandplonker

I'd like to stick to the scenario I gave and cut down on the jargon; before my head explodes.

JohnRo

Prothet_of_Doom wrote: »

Why ain't we all doing it?

capital
voids
agency fees
maintenance & repairs
insurances
hassle
ethics

grandplonker

Let's be clear as diplomacy allows:

Stop hijacking the thread.

The subject is the theory of leveraged investment and what returns you need to break even. Not the risk, or whether it's a good idea.

Anything else, start a new topic elsewhere.

Help is otherwise appreciated on post #13.

Linton

Prothet_of_Doom wrote: »

An IFA freind of mine, uses the word leverage.

If you have £10K you can borrow £100K, and provided the £100K makes more money than it costs you've made more.

Classic is BTL's £40K down, £60K borrowed, at 6% (£3600). Rent is £7K a year, house capital increase could be +/- 10%. (lets say 5%)

So Each year that £40K makes £8400

So on the £40K you make 21% ....Not risk free by any means.
If you borrowed the £40K in the first place of your parents, and gave them 5% (i.e £2K ....double what they might have got in the bank) you've made a stonking £6400 with zero investment.

Why ain't we all doing it?

But if you have £10K, borrow and invest £100K, and then the £100K investment halves in value you have £10K, £50K of investment and £100K of debt making a total of £-40K which could lead to bankruptcy. Leverage can greatly increase profits, but it equally greatly increases losses. So the advice should still be to restrict your investing such that you can afford to take the risks.