We all know what interest is. I like to look at it this way: Interest is a fee borrowers pay lenders to have access to a sum of money right away. Interest is a fee lenders charge borrowers to part with their money for a period of time. Interest is money rent.
People borrow money all the time for non-investing purposes. This includes using credit cards to buy clothing or other consumer goods and then paying the minimum balance (seems kind of dumb to me) and taking out an auto loan to buy a car. In these two examples (there are many more) not only is the borrowing for non-investing, it contributes to one losing money. Not paying off your credit card balance in full makes the clothing, or whatever consumer good, you buy much more expensive, since you're paying interest.
Should you wish to sell the clothing or other consumer good later on, you will get much less than you paid for. The same is true with buying a car. As soon as it leaves the lot, its value drops significantly. Of course, cars can help you make you money too, by getting you to work, or if it's an antique you're restoring, and so on. Nevertheless, these are common examples of people borrowing money to purchase assets that drop in value immediately after they are bought.
So how about borrowing money to buy something that has the potential to go up in value? People do this too. Common examples include borrowing to start a business or buying stock on margin. I'd like to talk about something similar to the latter, but without having a margin account.
Isn't investing with borrowed money risky? Sure, because you have all the risks that come with investing, but also you have the danger of losing money that's not yours to begin with. That is, you have the added danger of losing more than you invested. There are situations, however, when investing with borrowed funds can be to your benefit and with less risk than it seems. Consider the following three:
1. Borrowing to invest in risky asset classes. Suppose you bought a certificate of deposit or a safe bond (e.g. Treasury) when interest rates were much higher. In 2006, for instance, you could have purchased a 10 year CD paying 7%. Let's say you bought the 10 year CD for $10,000 in 2006, and in 2011 you find a personal loan at 5% interest. If you take out a $3,000 loan, the interest you earn on your CD will cover your monthly payments for the loan. This means that you can put the $3,000 in something risky like stocks without the fear of losing your principal. This can be better than a margin account at your brokerage because you can hold on to the stock much longer without feeling the effects of the up to 13% margin interest. It can also be used to buy something for which typical margin isn't available.
The example does not take fees and taxes into account (banks charge fees for loans, and you pay income tax on the interest you earn from your CDs. But since you can deduct the interest you pay on money you borrowed, there are balancing factors here that make it a bit complicated to calculate),* but you get the idea.
2. Borrowing to invest in risky asset classes where your monthly loan payment is less than your practically guaranteed monthly savings amount. This is a variation on number 1. Let's say you have a steady job that you're unlikely to lose. You're sure that you can save $300 a month for investing. You can put that money into an index fund every month (a very smart thing, in my opinion). But let's say you've found an investment that you think will yield you far better returns and with less risk. Perhaps you want to buy a foreign currency CD at something like EverBank, because you're sure the dollar will tumble against some other currency over the next few years.
The trouble is, while you have the $300 a month to invest, the minimum deposit amount is $10,000. At your current savings rate, it'll take you about 33 months to get enough money. But maybe you'll have missed the boat by then (doubtful) or the minimum deposit would be raised (quite possible) by then and you'd therefore miss out on a great investment opportunity. You need the $10,000 now (for Everbank or whatever investment you're interested in).
Suppose you can borrow the $10,000 over a 5 year term at a rate of 6.8% (the current low for personal loans). Your monthly payment (excluding fees) would be around $200. The monthly $300 you've budgeted for investing would easily pay for this, with around $100 left over (you could pay your loan off faster, so it would be cheaper). You have the $10,000 right away instead of waiting over two and a half years. This could be well worth the risk.
3. Borrowing to invest in essentially riskless asset classes like CDs, short term treasuries, and high interest online savings accounts. It was more common in the past, but we still receive 0% interest (for 1 or 2 years) balance transfer offers from credit card companies. (Hopefully you have no credit card debt. If you do, you should probably pay off your high interest debt before investing.)
Read the fine print very carefully. If everything's ok, accept the offer. Max out the balance transfer limit. The offerer credit card company usually sends you blank checks, that you draft and then send to the credit card from which you want to transfer your debt.
Given that you have no debt on the card from which you're "transferring" money, you will have a negative balance on that account. Call them up and ask for a refund check. Put this money where it'll be relatively liquid and yields are highest--an online savings account (for example, Washington Mutual's Online Savings currently yields 4.25%), a short term CD (currently the national average is around 3.26%), a money market account, or a short term treasury (a 6 month currently yielding 2.12%). Be sure to make the minimum monthly payments to the credit card you borrowed from. About a month or two before (just to play it safe) the 0% introductory rate period is up, pay off the amount in full.
While the earnings aren't great, it's basically free money. Be careful, though, do it to often and your credit score might be affected. Also, if using an online savings account, be sure to stay under your transaction limit, to avoid excessive activity fees and closure of your account.
All these strategies aren't for everyone. For example, I don't feel organized enough to attempt them. That is, a mistake could end up costing you money, making the entire scheme an unprofitable a waste of time.
Please see the comment below. Personal loan interest is not deductible. My understanding, however, is that because investment interest is deductible, and since you're using the loan to buy property for investment purposes, which "includes property that produces income, not derived in the ordinary course of a trade or business, from interest, dividends, annuities, or royalties," the interest you pay should be deductible. Please check with a tax professional. This site may be helpful. Here is the relevant section of the Internal Revenue Code.
I wish to be accurate on this issue and would appreciate further comment.