One of the big rules in investing is this: Never do anything with your money that you don’t understand. This is really true if you are thinking about borrowing to invest. It’s important to understand what can happen if an investment doesn’t work out.
How does leverage work?
Borrowing to invest is also called getting leverage, or leveraging. You can leverage by:
- Going to a bank and taking out a loan. You may use the equity in your home to back up or secure the loan. If you do this, what will happen if your investment loses money? You may have to sell your home to pay back the loan.
- Borrowing money through a brokerage firm. This is called buying on margin. If you do this, what will happen if things don’t work out? You will have to put more of your own money into your account to cover your losses. Make sure you have a back-up plan for how you would handle this problem.
- Short selling. Here you borrow shares of a stock from your brokerage firm, and sell them at their current price. If the share price falls, you buy back the shares on the open market at the lower price. Then you give back the borrowed shares.
- What will you do if the shares go up, not down, in value? You will lose money. You will have to pay more to buy the shares back and return them to your brokerage firm.
Is borrowing to invest right for me?
Ask yourself these five questions:
- Do I understand how borrowing to invest works?
- Am I comfortable with the risk in the investments I want to make?
- How much interest will I pay each month? How does that compare with what I hope to make from my investment?
- If interest rates rise, will my costs increase? Will rising prices reduce what I make on the money I borrow?
- What if I lose some, or even all of the money I make with the borrowed money? Can I afford those losses? Will I be able to pay back what I borrowed from my savings?
Tip: Before you even consider borrowing to invest, make sure you understand the basics of borrowing. For example, there are real dangers to using your home to borrow.
Remember: Before you borrow, make sure you can deal with the risks.
It’s always a good idea to talk to an adviser you can trust. Ask about other ways to leverage your investments. Borrowing is not the only way.
Content in this section is provided in partnership with the Investor Education Fund, a non-profit organization promoting financial literacy to Canadians. To find out more go to GetSmarterAboutMoney.ca.