Good Debt Explained: Why You May Want To Take Out A Loan To Invest

October 3, 2017

Good Debt Explained: Why You May Want To Take Out A Loan To Invest



  • Investing isn’t only about choosing the right stocks, it’s also about proper capital allocation.
  • Taking on leverage to invest can be smart but it can also be incredibly dumb.
  • From an historical perspective, it could be a very smart thing to be ready to refinance your home and invest in stocks.

Introduction

Buffett and Munger praise themselves for never taking out loans for Berkshire and one of the most famous Buffett quotes is:

“If you’re smart you don’t need debt, if you are not smart, you better stay far from debt.”

However, this is another half-truth that he tells the world.

54% of Berkshire’s assets are financed with a form of debt, either by using the free float from their insurance subsidiaries or subsidiary debt.

Figure 1: Total liabilities are 54% of assets at Berkshire. Source: Berkshire Hathaway.

So even if Buffett always uses debt to increase his returns, should we do the same? That’s the question I’ll answer in today’s article.

Investing With Leverage Allows For Outsized Returns

The gist of investing with leverage is that it allows for outsized returns as you can invest with other people’s money.

The most important thing is that the interest you are paying is lower than the return you achieve with your investment. This example on an investment mortgage clearly illustrates my point.

Figure 2: Leveraged investing example. Source: Author’s calculations.

Another benefit of borrowing is that over a long period of time, assets like real estate and stocks will appreciate as the economy grows and inflation lowers the value of money, but the loan taken will always remain the same. A loan is also an excellent hedge against high inflation that may come as a result of our current loose monetary policies.

So the goal is to find the lowest possible fixed interest rates, and where the payment period is as long as possible. Thus if you have a lot of equity in your home, it might be an opportunity to cash out in refinancing in order to invest in higher yielding investments. However, there are some things to be careful of.



Things To Be Wary Of When Leveraging Your Investments

If you use debt to invest, it’s usually called good debt, while using debt to buy things that don’t produce anything is called bad debt. Nevertheless, there are some things to keep in mind even when taking on good debt.

Lower your risk by taking a fixed interest rate.

Interest rates change all the time and therefore, borrowing at a fixed interest rate can take a lot of risk off the table and also be a potential bonus to your investment idea.

If inflation or interest rates increase, the yield of your investment will also increase while the interest costs on your loan will remain the same. This will increase your returns significantly and is especially attractive on loans with a maturity longer than 10 years.

Be sure to take the loan in the same currency the investment is in.

Taking a loan in one currency and then investing it somewhere where another currency’s yields are much higher can be very risky and the benefits could quickly turn into headwinds.

Those who invested in Russian bonds in 2014 hoping for a stable 8% yield, are now at a 50% lower yield and are enjoying a 50% capital loss at the same time due to the decline in the Russian ruble.

Figure 3: USD vs. RUB in the last 5 years. Source: XE.

In order to keep the risks low, always invest in the same currency because currency trading is best left to professionals.

Look at the risk of the asset you are investing in.

For example, the current cyclically adjusted price to earnings (CAPE) ratio of the S&P 500 is 30.83. This implies a return on the S&P 500 of 3.24% in the long term which surely doesn’t cover for any kind interest costs and therefore, the S&P 500 as an asset to invest borrowed money in is too risky.

Figure 4: S&P 500 CAPE ratio with the red line marking the 15 level which implies a return of 6.6%. Source: Multpl.

However, in 2009, the CAPE ratio fell below 15, which implies a long-term yield of 6.6% which is much higher than the 4% yield some get by refinancing their mortgage or on personal loans, especially in Europe.

And here comes the beautiful part of being able to take a loan for investing. The best time to invest in stocks or any other investment is in the midst of a recession and when everyone is very pessimistic. In such an environment, many assets are plain bargains and those who invest enjoy amazing returns.

Don’t forget, the S&P 500 is up more than 200% since 2009. Therefore, leaving the option to take a loan in a downturn is probably the best hedge you can get in this market. If nothing happens, great, you continue with your portfolio as is. However, if a market crash comes, you can have available liquidity to buy on the cheap what everybody else is selling on the cheap.

Avoid margin investments.

Margin investments are a type of leveraged investment that have a few very important flaws for investors. For example, if stock prices start to fall and your assets don’t sufficiently cover the loan anymore, you will get a margin call that will force you to sell your position at the worst possible time, i.e. when stocks are cheap. Additionally, the interest rates on margin are usually a bit higher than what can be found by carefully planning a leveraged investment.



Conclusion & What To Do

Given the highly inflated valuations the current market offers, it might not be the best time to take a loan to invest. However, it might be a great time to prepare one’s financial situation to be able to take a loan when it will be highly profitable to do so again. This might happen sooner than you think.

Take advantage of the historically low interest rates which will probably remain low until significant inflation hits the economy.

Figure 5: Historically low interest rates offer a great opportunity. Source: CS Investing.

So when the next recession hits the economy, there will be very low interest rates as central banks will do whatever it takes to keep the liquidity high. Stock prices will be low as investors will panic amidst the first recession after 8 years, and prepared investors will be able to take advantage of the perfect combination: low stock prices and low interest rates.

Think about it now so that you can be prepared when the opportunity presents itself. The last time it presented itself was in 2009 through 2012, before that, in 2002 and before that, in 1991. Thus, once in a decade, there’s a great time to leverage your investments, but not more than once in a decade.