You consider yourself something of a financial whiz: You’ve figured out that the average annual rate of return in a mutual fund is higher than the annual interest rate on a mortgage. So, what do you do? Do you borrow money in order to invest it, thinking that you’ve outsmarted the financial system?
If you’re like some wise guys out there, that’s exactly what you do. You may even brag to your friends about how you borrowed money to put into the stock market, and how your earnings there more than make up for what you have to pay back on the loan. If you’re especially brash, you may try to convince other people to do the same. But you’re playing with fire, and sooner or later you’re likely to get burned.
If you’ve followed God, Money & Me for a while, you likely already know how we feel about debt. It’s one of the chief forms of financial slavery out there, and it does no shortage of damage to your life. You may also know that we’re big fans of investing, because it’s one of the best ways to build wealth over the long term. And we’ve said before that you should never borrow money to invest. But if you’ve found a way to make more money on your investments than you’re paying in interest, are you the exception to the rule?
Absolutely not. Borrowing and investing are both risky propositions; combine the two and you create one very dangerous cocktail. No matter how careful you think you are, you can’t control the large economic factors that could cause your plan to collapse.
Let’s step back and examine how these sorts of schemes work. We’ve examined the benefits of the stock market and mutual funds before, and found that good mutual funds can average an annual return of 10% or more over their lifetimes. During upswings in the market (such as the current market trend), one year can yield returns of 15%, 20%, 25% or more. At the same time, interest rates for borrowing are at historic lows. Home mortgages right now are hovering around 3%, and many other unsecured loans are in the single digits for borrowers with good credit.
There is a population of people out there who look at this scenario and see an opportunity. They figure that 15% is a lot higher than 3%, and that they can make money by leveraging these forces against each other. So they borrow money, either by taking out a home mortgage or getting some kind of unsecured loan, and then put that money into a mutual fund. Their plan is for the money that they make investing to pay for the interest on the loan, and then some.
Here’s a hypothetical example: Say Bruce has $100,000 worth of equity on his house, and wants to get some of that cash to go play in the stock market. So he takes out a second mortgage or home equity loan for $100,000 and invests it in a mutual fund. If the fund pays 15% this year, he’ll earn $15,000. Meanwhile, he’ll only have to pay $3,000 in interest to the bank (plus a small amount of principle), leaving him with a healthy profit of more than $10,000. Sounds good, right?
Maybe not. While Bruce is busy patting himself on the back for his financial “genius,” he’s turned a blind eye to the huge risks that he’s unleashed on his financial life. There are a number of things that can go wrong to wreck his plan, and they’re all outside of his control.
Bruce has made two critical mistakes in this equation. The first is that he assumed that the value of his stocks or mutual funds will always go up. While well managed mutual funds usually do have a track record of gains over the long run, that’s no guarantee of continued success. A large-scale economic meltdown could send the value of his investments spiraling; all of a sudden, the cash that he expected to be making from the investments turns into losses. There’s no income there, and yet he’s still on the hook for paying back the money that he borrowed.
The second mistake that Bruce has made is to assume that home values would never go down. In a healthy economy, home values stay steady or even grow slightly each year. But in a down economy, home values can plummet quickly. If the value of Bruce’s home goes down, that $100,000 of equity that he thought he had can cave in around him. If he has taken a $100,000 mortgage against that equity, he’ll find himself underwater, owing more on the house than it’s worth. That means that he can’t sell the house to pay off the loans, and he can’t refinance them.
Now, what would happen if both of these disasters occurred simultaneously — if the value of Bruce’s home plummeted at the same time that his investments started losing money? He would be up a creek without a paddle. He still owes money on the loan, and he’s still paying interest, but he has no investment income to offset that expense. That leaves him having to come up with cash out of his monthly income to cover the payments, badly damaging his family’s budget. And it gets even worse: If Bruce is unlucky enough to lose his job during this tough time, then he’ll have no way at all of paying back the loan. He’ll be on the verge of bankruptcy, endangering his family’s finances for years to come.
This may sound like a nightmare scenario, and if you find yourself in the middle of it, it will certainly be terrifying. But it’s not just speculation or a scare tactic — it actually happened back in 2008 and 2009. During that period, the stock market took a terrible tumble, home values fell drastically in some areas, and the economic tempest caused a steep spike in unemployment. The national and global economies are still trying to dig their way out of the mess. And people like Bruce who borrowed money to invest during that time are now battered, broke and full of financial regret.
Here’s the moral of the story: If you think you can use debt to make money investing, then you’re not doing a very good job of calculating risk. While it’s true that you could make money in theory, the huge risks of this method outweigh any of the perceived benefits.
Remember, there’s only one tried-and-true way to build wealth: “Whoever gathers money little by little makes it grow.”
Photo by Phil Hawksworth. Used under Creative Commons License.