I read the stock market averages 8% a year. Does it make sense to borrow money at 5% and invest it? This seems too easy, yet people aren’t doing it. What am I missing?
On the surface this sort of plan looks like a good deal. It’s true the stock market tends to offer around 7% or 8% returns, on average. And it is also true you can get a line of credit for around 6% annual interest. This means, in theory, if you borrowed $10,000, by the end of the year you’d have made about $800 from your investments and owe about $600 in interest on your loan. You’d have made $200 and without doing any work!
So why aren’t more people trying this?
The issues are in the assumptions. While it is true the stock market does tend to average around 8% returns over time, this measurement is taken over the span of a few decades. In other words, if you invested money 12 years ago it would probably have grown at a rate of 8% per year on average and doubled by now. However, over the span of those 12 years you’d probably have a handful of years where the market dropped, a bunch where it went up significantly, and a few where it grew slowly. The market doesn’t steadily go up 8% every year, it has some gut-wrenching years (such as 2001 and 2008) where it drops like a stone thrown out of an airplane. Other years it grows rapidly and offers great returns.
As an example, if you decided to try this borrow-to-invest trick in mid-2007 to put $10,000 in the market, by the end of 2008 you’d be out about $3,000, plus the interest on your loan. On the other hand, if you started your investment trick in April of 2020 then you’d have made nearly $7,000 by the end of 2021.
In other words, when you put money into the market, in the short-term, you’re taking a risk on whether it’ll go up or down. Over a decade it’ll almost certainly go up, but in the first few years you could be making money or losing it.
At the same time, the interest on your loan is going to remain steady. Your bank will expect you to pay the loan whether you make money in the stock market or not. Which means even if the market doesn’t go down, if it just holds steady, you’re going to make no money and owe $600 to the bank. That’s not a great position to be in.
This is also assuming your bank doesn’t raise interest rates on your line of credit. Right now it might be 5% or 6%, but what if in five years they increase the interest rate to 8%? At that point you would be putting all your money from the stock market into paying for the loan and not making anything, even on the pretty good investment years.
One more speed bump in this plan is that it tends not to yield a lot of money even if it does work. As I mentioned before, if you borrow $10,000 at 6% and invest it at a steady 8% you can make up to around $200 a year. This is assuming you’re putting your money into an investment where you won’t need to pay taxes on the earnings (a tax free savings account, also known as a TFSA is one such investment option). And that is on a good year. Now I’m not one to turn down $200, but if that is what I stand to make if the plan goes perfectly and I could be out a few thousand dollars if it goes badly, then I’m looking at some pretty high risk for relatively low reward with this plan. I’d make almost the same amount of money doing a shift or two in a minimum wage job. Alternatively I could save this amount by giving up coffee for six months and it wouldn’t carry any of the financial risks.
In short, this plan can work (sometimes), but it can also backfire in an expensive way. You’d be just as far ahead taking one extra shift at an entry level job or giving up drinking for Lent as you would if this plan works, and dodge the risks involved at the same time.
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