7 Ways to Borrow to Invest and Risks to Consider


Bradley Schnitzer

Last Updated:

Money

The key to wealth is making your money work for you by investing it wisely, but you might not be earning enough to see the returns you want. 

Fortunately, you can make other people’s money work for you as well by borrowing to invest. Below are several ways to do so.

Whichever way you choose, be aware of the risks involved, and remember only to invest money that you can afford to lose.

1. Borrow against your home equity

  • Sources: Banks, credit unions, and financing/lending companies.
  • Interest rates: 2.50%-9.99%.
  • Requirements: At least 20% equity in your home, low debt-to-income ratio, and strong credit score.
  • Repayment process: Fixed monthly payments for both home equity loans. Monthly payments based on use for lines of credit (HELOC).

Do you have a lot of equity in your home? You can leverage that equity to invest with a home equity loan or home equity line of credit (HELOC). Loans charge fixed interest rates, while HELOC rates vary with the Prime Rate.

The type of home equity debt you use depends on your investment needs. Home equity loans are suitable for Investments that produce income and moderate returns — such as dividend-paying stocks — because you will begin generating a substantial amount of income right away.

If you’re willing to forgo investment income in favor of aggressive growth, a home equity line of credit might be the better choice. By keeping your home equity on tap, you can take advantage of dollar-cost averaging — the practice of investing a small, fixed sum regularly over a long timeframe. Dollar-cost averaging helps you reap the advantages of assets that grow faster

2. Margin investing

  • Sources: Investment brokerages.
  • Interest rates: Generally, 1-2% above the Bank of Canada’s Prime Rate.
  • Requirements: Margin account and sufficient balance that varies by broker.
  • Repayment process: Flexible repayment unless broker issues a margin call.

Margin investing — also known as buying on the margin — is the practice of borrowing cash from your investment firm to buy stocks. Using this leverage, you can earn much higher returns on the same initial investment.

To buy on the margin, you open a margin account with your broker and deposit sufficient cash to meet their minimum balance requirement. This account serves as collateral for the loan.

From there, the Investment Industry Regulatory Organization of Canada (IIROC) permits brokers to lend you up to 70% of the value of the securities you’d like to buy, depending on the type of securities. Brokers can set more stringent requirements, though.

Once you borrow, interest begins accruing.

A quick example to illustrate your potential returns:

You have $5,000 in a margin account that requires you to hold 50% of the purchase price of any investment you’d like to make. You borrow $5,000, giving you $10,000 total, then buy 1,000 shares of Stock A at $10/share. 

Stock A increases to $12/share, at which you sell and collect $12,000, then you pay back the $5,000 and walk away with a gain of $2,000 minus interest and commissions.

Had you only invested your $5,000 (buying you 500 shares), you would have a gain of $1,000 minus commissions upon selling.

Higher potential reward comes with higher risks, however — get it wrong, and you’ll owe much more than you initially borrowed plus interest and commissions.

Back to the previous example. If Stock A dropped to $8/share, you’d collect $8,000 and pay back $5,000, walking away with $3,000. This results in a loss of $2,000 plus interest and commissions. Perhaps it dropped to $4/share, though. You’d have lost $6,000, more than your initial investment — and you still owe the margin amount to the broker.

You can always wait longer for the stock to increase again, but you’ll pay more interest over time.

Lastly, your broker may initiate a margin call if your stock values fall below the minimum account threshold. During a margin call, you must deposit cash to bring your balance up to the threshold — otherwise, the broker can liquidate your securities to fulfill the requirements.

3. Short selling

  • Sources: Investment brokerages.
  • Interest rates: Generally, 1-2% above the Bank of Canada’s Prime Rate.
  • Requirements: Margin account and sufficient balance that varies by broker.
  • Repayment process: Buying the stocks back and returning them to the broker.

Short selling, or taking a short position, is a form of margin investing that involves borrowing stocks and selling them immediately, putting the proceeds in your margin account as collateral. 

The goal of short selling is to buy the stocks back later at a lower price and sell them to profit. Brokers supply you with a margin account in which you store cash as collateral for the stocks.

For example, you short 100 shares of Stock A at $20/share. Your revenue is $2,000. Stock A then drops to $15 per share, at which point you buy the 100 shares back and return them to the owner. Your profit is $500 minus commissions and interest.

If you’ve got an eye for predicting market trends, short selling can make you good money — but remember that any form of margin investing is much riskier than sticking with your own cash.

4. Personal loan

  • Sources: Banks, credit unions, and financing/lending companies.
  • Interest rates: Around 7%-12% for banks. 14%-30% through financing companies.
  • Requirements: Good credit. Collateral for secured loans.
  • Repayment Process: Fixed payments each month.

If you have good credit, you could take out a personal loan and use the funds to invest. These types of loans are easy to get, requiring a quick application and credit check.

Interest rates vary depending on:

  • Credit score
  • Amount borrowed
  • Loan term
  • Whether the loan is secured or unsecured

One drawback to using personal loans is you only get a fixed amount. Once you take out the loan and invest, you’d have to apply for another loan if you want to borrow more.

Tracking your repayment is easy, though. 

Also, as lump sums of money, personal loans are useful for purchasing an income-generating asset.

5. Pawnshop loan

  • Sources: Pawn shops.
  • Interest rates: 20%-30% per month.
  • Requirements: An item for collateral.
  • Repayment process: Must pay back the loan within 30 days.

If your credit is poor or you’d rather not go through a bank, you can pawn one of your items and get a loan. No credit checks nor employment are required, and approval is fast.

You have 30 days to pay back the principal plus interest and fees within a 30 day period. Otherwise, the pawnshop seizes control of your item.

Interest rates are pretty high, however, making pawn loans tough to pay back.

Not ideal, but there’s a hidden benefit — failure to pay back your pawn loan doesn’t hurt your credit score. 

6. Credit card cash advance

  • Sources: Credit card companies.
  • Interest rates: 20% or more, along with cash advance fees.
  • Requirements: A credit card with enough available credit that allows cash advances.
  • Repayment Process: Flexible repayment. Must make minimum payment plus more to ensure the lender applies payment to the cash advance.

Few brokers, if any, accept credit cards for buying stocks. It’s too risky for you, and they want to promote their own forms of borrowing to invest (more on that below).

However, you can take out a cash advance with your credit card and use your cash to invest. To do so, visit an ATM with a credit card that allows cash advances.

Cash advances aren’t advisable. Their APRs are excessive, for one. Few investments will produce a greater return than your cash advance’s interest rate.

But you also have to pay a cash advance fee — typically the greater of 5% of the amount withdrawn or $10.

7. Personal line of credit

  • Sources: Banks, credit unions, and financing/lending companies.
  • Interest rates: Based on the Bank of Canada’s Prime Rate (2.45% as of April 8th, 2020) and your credit score.
  • Requirements: Good credit.
  • Repayment process: Flexible repayment. Must make the minimum payment.

Lines of credit are a hybrid of loans and credit cards, letting you borrow as much as you need, up to your credit limit. To borrow, you can write a cheque against your credit line, use an ATM, use online banking, or pay for things over the phone.

Interest rates are quite low, as they are based on the Bank of Canada’s prime rate. The lender adds a small percentage to arrive at your interest rate.

Like loans, lines of credit can be secured or unsecured. Secured credit lines will be easier to open and have lower rates than unsecured credit lines.

Keep in mind, however, that the Bank of Canada can increase its prime rate. If they do so, you could find yourself unable to pay back the money you borrowed.

As for repayment, you receive a monthly statement containing the minimum payment and total amount totoot pay back.

Risks to consider when borrowing to invest

Investing your cash in stocks can earn you a higher return than storing it in a savings account, but there’s more risk involved.

When you add other people’s money to the mix, there’s even more potential downside. Here are some risks to consider when borrowing to invest.

Interest rate vs. potential returns

Think of your interest rate as a negative ROI. When you borrow someone else’s money, their “ROI” is your interest — thus, your interest rate is a negative return.

Consequently, you’re losing money if your interest rate is higher than your ROI. 

A personal credit line may be a good choice for borrowing to invest, as their interest rates will likely be lower than the returns you earn. Same with borrowing against your home equity.

Margin accounts are also low-interest options, should you meet the requirements.

On the other hand, you’d be better off avoiding methods like cash advances — few investments will have returns that best a 20% or higher APR.

Cash flows

Perhaps more important than your returns is your ability to pay back the debt. You must be able to cover the principal and interest, as well as trading commissions. You won’t be able to use your investment returns without liquidating the investments — causing you to lose out on future returns and incur tax liabilities.

For traditional borrowing methods, such as loans and credit cards, failure to cover your payment obligations can lead to interest charges, late fees, and credit score damage.

Broker-supported borrowing methods like margin investing and short-selling are different. If your account balance falls below minimum requirements, the broker can demand that you deposit more cash to compensate through a margin call — or they can liquidate your securities to meet the requirements if you can’t add cash.

Collateral

Whenever you use secured debt, your collateral is on the line. Factor in the collateral’s value to you as you determine if you want to invest, as you may be willing to lose some forms of collateral over others.

For example, you may have a piece of fine jewelry you use as collateral. Perhaps you’re unable to pay back the loan, causing the lender to seize possession of the jewelry. While not ideal, you can still live without a piece of jewelry or two.

But things change if the collateral is your house. Should you be unable to pay back your debt, you can lose your home — much worse than giving up some diamond earrings.

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Over to you

We’d love to know — have you ever borrowed money to invest before? Were you able to earn higher returns by doing so? Did we leave out any methods you’ve used successfully? Let us know in the comments below.

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