Borrowing to invest is twice as risky
25 February, 2015
It has been a while since a headline gave me that "uh-oh, this isn't right" feeling. I get cross with lots of headlines because they are unnecessarily scary or exaggerated but this one was something again.
When I saw an Australian finance column headed "Got the guts to gear?" I thought, 'here we go again, enticing investors to do the wrong thing at precisely the wrong time'.
The premise of the column was that, as interest rates on loans fall and share market yields remain strong, investors might like to consider borrowing to invest. It looked at the current valuation and dividend yield of the Australian share market and concluded that, if you borrowed money to buy a share portfolio today, the portfolio would easily generate sufficient dividends to service the borrowing costs. So: "perhaps a little extra risk is worth considering".
To give the author his due, the article was peppered with caveats and used soft words like "perhaps" and "could" rather than "should" to ensure that nobody interpreted his suggestion as a guaranteed path to riches. Nevertheless the reader was left with the clear impression that they were looking a gift horse in the mouth.
When I saw a very similar article in the British financial press, extolling the virtues of using low mortgage rates and record house values to borrow to invest in rental properties, the sinking feeling arrived. History has invariably shown investors flock to 'sure to win' investments just as markets turn, leaving them disappointed and out of pocket.
The borrowing to invest argument is a fairly easy one to mount at the moment. In the Australian article, the figures certainly stacked up. It assumed a hypothetical portfolio of $A100,000, borrowed at 4.75 per cent per annum over a five-year period. The annual borrowing costs would be $A4,750.
Currently the Australian share market is paying an average dividend yield of 4.35 per cent or $A4,350 per annum on a $A100,000 portfolio. Australian investors receive franking credits on dividends paid, which essentially reimburse investors for the tax the company has already paid on its earnings before distributing the dividend.
Assuming a franking rate of 75 per cent, the annual dividend increases to $A5,748 which is well ahead of the borrowing costs, hence the author's suggested strategy. This hypothetical example is simplistic and fails to mention, for example, that the interest on your mortgage needs to be paid monthly, whereas the dividend is only received six-monthly or annually — but you can nevertheless see the logic in the argument.
What is more, if you were able to achieve some capital growth in your portfolio, the deal looks even more exciting.
The article says: "As investors looking at the lowest interest rates in a generation, we would be doing ourselves a disservice not to at least consider borrowing". No, it is a disservice to encourage people who really shouldn't borrow to think they should.
Borrowing means accepting risk. Investing in shares means accepting risk. Borrowing to invest in the share market is like turbo-charging your risk. This strategy only makes sense for certain investors with a large appetite and ability to withstand any change in the lending environment.
While the numbers may look compelling right now, they can change at any time without notice. When borrowing is involved, a small change can have an outsized impact. The scenario becomes significantly less compelling if interest rates rise, share market values fall or company dividend payouts reduce. All of these things are within the realms of possibility.
The article referred to historically low interest rates offering a 'fascinating' opportunity to borrow to invest. An equally fascinating opportunity exists to use low interest rates to reduce debt faster than you could when interest rates were higher.
Anyone who takes the opportunity to re-mortgage at a lower interest rate, keeping repayments at their existing level, can sit back and watch their total debt plummet. Maybe it's not as exciting as borrowing to invest, but excitement in investment markets can be overrated.
There will always be investment opportunities where the numbers appear to add up ... the point is, they don't always add up for everyone.