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Don't borrow to invest

Jan 12, 2011

Many people try to borrow money to invest in stocks. The reason for this is that it helps one in having more money to buy more of a particular stock. And if one buys more quantity of a stock then the returns would be much higher.

But, borrowing money to invest in stocks though sounds tempting but is not a very good idea. Yes on the upside the extra capital that comes with the borrowed money does magnify your returns. But on the downside it magnifies the losses.

Let us see through an example how magnification takes place:

Suppose an investor intends to invest a total of Rs 1,000 in a particular stock. Say if he contributes Rs 500 from his own capital and borrows the remaining half. Now letís say the stock price goes up by 10%. He earns 10% of Rs 500 on his own capital and another 10% on Rs 500 of the borrowed capital. So total return is Rs 100 as against Rs 50 which is what he would have earned had he not borrowed the funds.

But there is a catch here. The extra capital (magnifier) comes with an interest cost. The prevailing interest rate for short term funds is high. It can be as high as 20-22% on an annual basis.

The borrower is obligated to pay back the borrowed funds along with the interest costs. Mind you this is irrespective of the movement in the stock price. For instance, if you are invested in a stock and the price remains flat for a while, the borrower still has to bear the interest cost thus taking the cost of the investment higher. Therefore, in order to profit from the investment the borrower will have to recover the interest cost as well.

Even a decent return of 25-30% on a stock will result in lower actual return in the hands of the borrower.

Letís understand how this works with the help of an example. Suppose the stock goes down instead of going up. Letís say the investor has borrowed money at an interest rate of 10% and invested this amount in a stock that goes down by 20%. This means that the invested amount in the stock is down by 20%. In addition to this, there is the interest burden of 10% as well. So the total loss becomes 30%.

Apart from the discussed drawbacks, borrowing to invest also exposes investors to a lot of risk. The scariest being the risk of losing more than your own capital you actually invested.

The risk to wipe off the earnings is a main reason for staying away from borrowed funds. The idea, after all, is to earn better returns on savings not to lose all of it in paying back interest.

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