Taking out a loan to buy your own home or to invest in real estate are usually sound reasons for borrowing money. However, there may also be other investment situations in which it makes sense to borrow money. Before taking out any loan, it is important to always remember that there is an opportunity cost whenever you are considering any investment. Any money that is invested in one opportunity cannot be invested in another. Therefore, you must carefully weigh your options whenever borrowing for investment purposes. Real estate, for example, is an illiquid investment and the funds tied up in real property may not be available for other investments which may provide higher rates of return and offer more liquidity.
Borrowing for investment can be a wise choice when it is done in order to diversify an investment portfolio. This helps to reduce overall risk by not having all your investments in one form, such as only real estate or only stocks. For example, one could borrow against the equity in one’s home in order to purchase stock or other liquid assets, thus spreading investment risk over a wider range of investment types.
Another situation in which one could borrow for investment purposes would be to borrow at a certain rate and invest the money into an investment which has the potential to yield a higher rate of return than the interest rate on the funds that were borrowed. For example, if you took out a loan at an interest rate of 8% and the investment produced an annual rate of return of 12%, you would have a profit. This form of borrowing for investment can be fairly high risk and even speculative at times. The investment may not yield as a high a return as expected.
Another situation in which borrowing for investment may make sense is to leverage equity and use it for other purposes. For example, a manufacturing business may want to borrow against equity they have in their buildings and land and invest in inventory, equipment or other capital investments that will produce more profit.
There may also be some tax advantages in borrowing for investment purposes. Mortgage interest is usually tax deductible. One could take out a home equity loan and invest in tax-deferred or tax-free investments and deduct the mortgage interest on the loan.
Whenever one is borrowing for investment purposes there are always risk involved, in addition to opportunity costs. If one is borrowing against equity in one’s home or business property, you are putting that property at risk if your investment strategies backfire or do not perform up to your expectations. Employing financial leverage can be very profitable, but you must assess the risks as well before borrowing.