Is it smart to get a loan to invest in stocks?
Heard of a new IPO in the market and you’re confident it will over-perform? Or a blue-chip company raising a lot of capital and showing high growth potential and you want to grab the opportunity before its too late, but don’t have the funds for it? There are various reasons one might consider taking a personal loan to invest in the stock market. An avid trader is also sometimes lured by the high returns that equity instruments offer.
However, taking a personal loan from the bank on interest to invest in stocks or mutual funds to gain returns is not always a good decision for your financial health. This process of ‘Give and take’ is termed as “Gearing or Leveraging” in the capital market. Investors opt for it in hopes of earning a hefty profit or accumulating a large wealth corpus. When in reality, the chances of that happening are very low and it involves a great amount of risk.
And you know, stock investing and trading can be tricky. A demat account with a reliable stock broker, understanding the stock market basics, and having sufficient funds to invest are the main pre-requisites. But, should you use a personal loan to invest in the vibrant stock market?
Experts of the industry claim that the only time it is justified for you to take a loan is during asset-building like home loans or a financial emergency like natural disasters or medical aid. Read on as we discuss further reasons why you should not take personal loans to trade for stock investments.
Personal Loans for The Stock market: A Big NO.
Giving Exciting offers like low-interest rates, higher credit rating, or other non-monetary advantages, banks try to sell you a loan. Taking a personal loan nowadays is a child’s work. Gone are the days when we had to wait in lines and submit physical forms in order to take a loan. Today, you can just visit a bank’s online portal and apply for one, considering your credit score.
On top of this, there are many other ways of loan procurement like Peer-to-peer lending where a group of people come together to lend and borrow among themselves to remove the middleman and earn higher returns. Many startups are capturing a good market share with this initiative. Another such example is Non-Banking Financial Companies (NBFCs) that do not have a full banking license but provide loans to its clients on a lesser interest rate.
However, you should not forget that no matter how convenient or accessible a loan may look, it is still a debt and employing debt money in a volatile market comes with its consequences.
Risk of Falling into a Debt Trap
Have you noticed the disclaimer dialogue always associated with Mutual funds?
“Mutual Fund investments are subject to market risks, kindly read the offer document carefully before investing”.
Yes, of course, you know there is a risk factor in the market. But a smart investor knows when and how to dodge that risk and create wealth. No matter how well a fund or stock is performing in the market, it is always subject to risk.
A recent example is the Franklin Templeton Debt fund de-listing itself leaving thousands in a state of worry. History has a track of recessions or downfalls that even Large-capital companies could not withstand. The Economic crisis of 2008 was a reminder of this fact. So, when you take a loan to invest in some stock and it goes through an unexpected downfall, all your capital raised would be lost leaving with you with additional debt to pay.
What will happen then?
A new loan to repay the last one? This is a debt trap you don’t want to find yourself in. There are many ways this could happen in the given circumstances. Suppose you took a personal loan on 12% and invest it in a fund that you thought would garner just enough returns to pay off the debt. If the issuing bank’s interest on loan increases by even 1-2%, you would find yourself in losses. A change in the Bank’s interest rate could affect your return earning on investment.
Liquidity and Concentration Issues
Another way loaned funds are at risk are Liquidity and Concentration issues. Penny stocks can turn liquid over time leading to capital loss. On the other hand, the biggest mistake one can make is concentrating on only one stock or having a non-diversified portfolio. The underper-formance of such assets, especially when they are bought with borrowed amounts can have a very negative impact on your finances.
Let’s have a look at an example. A passionate trader of the stock market invested in mid-cap and small-cap funds by taking up a personal loan of Rs. 5 Lakh. He describes this decision as to the biggest blunder of his life. Why so? Sensex fell down by 3000 points during the time leading to high losses on top of a payable loan.
Risk of Interest Rates Surpassing Earnings
A personal loan is mostly around 14-16% interest rate. Let’s say you take one to invest in Equity Mutual Funds. You would naturally expect the ROI to be greater than 16% in order to make profits. However, if we talk about the historical returns offered by Equity MFs, it comes around an average of 12-13% in case of best performing funds which stabilizes to 10-12% over a period of time. See the difference? Even if you’re lucky there is less chance for you make any net profit from such an endeavor.
In addition to high-interest rates, timing the market is not quite easy. Your loan repayment cycle might not match the interest-earning time from a fund leading to a state of agony since lack of availability of funds was the reason you took the loan in the first place.
Before taking up a personal loan ask yourself these questions
Am I capable of undertaking such a risk?
Do I have a backup loan-repayment option if things were to go wrong?
Will the returns I generate from investment pay the loan interest?
If you answered NO in anyone of those. Personal loans for stock investing is not the way for you to go. However, if you answered YES to them, and are keen on taking a loan, refer to the below-mentioned factors.
Factors to Consider While Taking Personal Loan for Stock Market Investments
Everyone has their own capability of handling risk in the capital market. Some are aggressive investors who trade on ‘high risk and high returns’ motto while others are conservative and desire slow and steady growth in the market. If you recognize with the former person, loans can be considered as a medium to raise money and generate short term profits.
2. Low-interest Rates
If you have an investment option where the bank is offering loans on extremely low interest and you are confident that the financial product you’re investing in, will garner more returns than the interest paid, then it could be a profitable venture. Many a times such offers arise and the one who grabs them wins them.
3. Strong Knowledge of the Market
The stock market is your strong suit and you have been an avid investor for a long time. After diligent and advanced technical analysis of a company, you are sure that it will produce great returns. Then, and only then should you consider taking debt to invest it.
Well-informed decisions act as a root base for your financial health. I hope this article helped you determine whether or not you’re in the state of taking a personal loan to invest in the stock market.