BY FAZAAD BACCHUS
Often times we hear that someone has borrowed money with the intention to invest it into stocks, bonds or mutual funds. You may have even received a call from financial firms suggesting that this is a good strategy in which to grow your wealth.
What’s the idea behind this? An advisor who works in conjunction with a loan and investment facility approaches you with the idea that you can borrow money at a rate of let’s say 5% and the said sum will be reinvested of course through him at a rate of 8%. Instantly you think that this is not a bad idea as simple calculation tells you that you will be earning 3% for doing nothing. What’s worse is the advisor may intimate that some of his funds earned in excess of 10% the year before and that’s when the typical customer gets hooked.
Greed steps in, calculations are now running in excess of 5% and you have to do no work. Actually the advisor says that the way most people get rich is by using other people’s money and this is what will make you rich as well. This type of transaction is frowned upon by most finance companies and the implementation of it now follows very strict guidelines. What are the drawbacks of such an investment strategy?
Let’s say you borrow $100,000, your loan payment is approximately $450.00 monthly as you are only paying the interest. If the market is in an upswing and your investment is growing each month then it’s all smiles by everyone, but historical performance is not a guarantee for future performance and so the pendulum swings. When it does and depending on what you are invested in, your investment can fall rapidly. Over the last year, I have seen some unfortunate cases where people they have lost as much as 20% of their portfolio.
So in the present scenario, you now have a $100,000 investment which has a market value of $80,000 and you are considering calling it quits, but you can’t. Why? Well of course if you do, there is a balance of $20,000 to repay. Depression steps in; there is anger at the advisor, the finance industry and everyone else who can be blamed. The advisor on the other hand has since left the industry and quite literally you don’t know what to do. You can’t sell, don’t want to keep and everyday things get sour. And of course the monthly payment of $450.00 continues, this tears a hole in your wallet now, because the investment no longer supports the payment.
You eventually do like most individuals and you cash in and promise yourself that you will never make another investment as long as you live. However how do you protect yourself from falling into such a predicament?
First, understand your cash flow, if you cannot pay the loan from your current income, then don’t get into it. You will not be able to depend on distributions from the fund to pay the monthly loan amount. Second, do not overextend yourself. Try a little just to see how it works, certainly do not surpass borrowing more than six months income. You need to get a feel for investing before you go too deep into it. Third, make sure that the advisor prepares a leverage worksheet for you. This will inform you of your debt service ratio and your limits to borrow.
If you haven’t lived through such a situation, you are very fortunate. However if you have had the unfortunate experience and don’t know where to turn, drop me a line and I will see how to help.