Are you wondering whether you can borrow money to purchase stocks? Well, the short answer is yes. However, you need to know a few things before you start borrowing money to buy stocks.
Investing in stocks is like any other type of investment. The reason for this is because it involves staking your money with the hope of getting returns. Borrowing money for investment is known as leverage and is a risky undertaking. Whereas you may reap big when the prices are high, you could also incur significant losses if markets fall.
Do not forget that you must repay your loan, including the interest. THis is true whether you get profits or losses from your investment. Therefore, it’s a high-risk investment strategy for experienced traders. We’ll help you understand the risks involved in taking out credit to buy stock. We will also cover how you can try to mitigate such eventualities.
Current Macroeconomic Conditions and Impact on Stock Investments
Before you start borrowing money to buy stocks, pause and look at current macroeconomic conditions. If we can jog your memory for a moment, you can probably remember the market crash of 2020. The reason for this really had to do with the COVID-19 pandemic. This, and other impacts, resulted in stocks plunging downwards. Analysts report that it was the worst plunge since the great recession of 2008.
A lot has happened in 2022, from high inflation to rising interest rates. Investors are not sure what lies ahead. According to the U.S. Labor Department report published on October 13, 2022, the annual inflation rate for the U.S currently stands at 8.2% for twelve months ending September 30, 2022. This is a significant increase compared to the 5.39% attained in the same period last year (2021).
Even though the turmoil witnessed in 2020 was high, Wall Street has experienced somewhat uncertain movements this year. Stocks have been falling and staging brief recoveries before tumbling again. It could be due to the mounting panic globally due to high inflation, weakening currencies, and the Russian-Ukraine war.
Whereas there are many unanswered concerns about the possibility of a recession, investors are watching closely as central banks around the world hike interest rates to combat persistently high inflation.
Typically when interest rates rise, the consumer spending power drops because there’s less money in circulation. Eventually, this leads to low demand for goods and services and a price drop.
Unusually this year, the Fed has been increasing the base rate every month with the hope of controlling inflation. Indeed, in tightening the current financial conditions, the Fed raised funds’ target by 75 basis points. Analysts predict the rates might increase by up to 4.5% by the end of the year.
As you can see, economic conditions can seriously impact your decision of borrowing money to buy stocks.
Impact of Rising Interests on Borrowers
As the Fed continues to increase the funds’ rates, the banks will likely slap borrowers with high-interest rates on their loans. The rate hikes affect your loan’s annual percentage rate (APR). This is the rate that determines the interest payable on the outstanding loan balance. When the Fed hikes started in 2022, the credit card APRs hovered around 16%. Currently, the rate has climbed to above 18% for travel cards.
Even though analysts had predicted the APR on a 30-year fixed mortgage rate to stay below 5.5% by the end of 2022, it has climbed to 7.21%. A similar scenario is replicated in other types of credit, including investment, auto, salary, and online loans.
Considering the current macroeconomic conditions explained above, if you borrow to finance the purchase of shares now, chances are you’ll be paying high interest on your outstanding balance.
Taking Out a Loan to Finance Share Purchases
A loan to finance the purchase of shares, managed funds, and exchange-traded funds (ETFs) is a margin loan. Normally, your margin lender may require you to maintain the loan-to-value ratio (LVR) below a certain level, normally 70%.
The LVR increases when there’s a decline in the value of your investments. If the LVR increases above the agreed limit, the lender may require you to lower it to the allowable level within the specified time.
In this case, you can deposit more money to lower the LVR, increase your portfolio value, sell your shares and pay off the loan. If you cannot lower your LVR, your lender may sell some of your shares. This type of loan might be a high-risk option that may lead to significant losses due to the current economic situation.
Understanding what your LVR is, and what your obligations are regarding paying off a margin loan is very important if you are considering borrowing money to buy stocks.
How to Mitigate the Risks of Margin Loans
You can manage the risks of borrowing to finance shares by taking the following steps;
- Shop around for the most favorable deals. Even though lenders are faced with the same macroeconomic conditions, some other factors may affect the cost of borrowing, such as; operational costs and years in business. Online lenders often don’t have physical branches, so their operational costs are lower than traditional lenders. For instance, CreditNinja is an online lender that allows borrowers to get credit from almost anywhere.
- Consider fixed-rate loans since they’re not affected by external factors.
- Borrow below the 30% credit utilization rule to avoid overborrowing which may affect your credit report.
- Diversify your investments to spread out the risks.
Borrowing Money to Buy Stocks – The Final Word
Borrowing money to finance the purchase of shares can lead to bigger losses when interest rates keep increasing. It can also lead to a capital risk if your investment value decreases and you have to sell quickly to avoid more losses. It’s essential to seek advice from an experienced financial advisor before you borrow and invest.