Investing With Borrowed Money

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.

* Update:

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.

This Week's Random Stock List

Here's this week's random stock list with closing prices as of Friday 2/8/08. More about the experiment here.

1. Modine Manufacturing Co. (MOD) $13.68
2. Auxilium Pharmaceuticals, Inc. (AUXL) $33.33
3. The Pantry, Inc. (PTRY) $27.42
4. PetSmart, Inc. (PETM) $23.73
5. Coca-Cola Enterprises, Inc. (CCE) $23.28
6. Mid-America Apartment Communities, Inc. REIT (MAA) $46.44
7. Omega Protein Corp. (OME) $7.71
8. Omniture, Inc. (OMTR) $25.98
9. Cooper Tire & Rubber Co. (CTB) $17.25
10. Cumulus Media Inc. (CMLS) $6.07


Paying for College & Also Paying for Barrons, etc? You're Probably Paying Twice

Most colleges subscribe to various databases. If you're paying for college (grad school, etc), whether for yourself or someone else, fees for these databases are included in your tuition.

Two databases in particular, Lexis Nexis and Proquest, give you access to many financial/investing publications. These include, but are by no means limited to, Barron's, Business Week, The Economist, Forbes, Kiplinger's, Money, and The Wall Street Journal.

If you subscribe to any of these separately, and you're paying for college, you're paying twice. If you're paying for college and don't read any of these, maybe you should, since you're paying for them anyway.

It's true that the database versions don't have pictures and if you want to read them without a computer you have to print them out. The databases also, with some exceptions, don't provide you with the various online features of the publications. Nevertheless, it's certainly worth it if you save $100 a year (a Barron's subscription, for example) or more, don't you think?

It's easy to find out what you're already paying for. Just visit your (or your kid's, spouse's, etc) college library website and poke around. You might discover a lot of useful publications that you're already paying for. Most libraries now have proxy servers, so you don't even have to leave your home. If you're not the student, you might need a little help (to connect you probably need a student id, or password).

Some college libraries have access to an even broader array of financial publications. For example, through mine I can use Morningstar, Standard & Poor's NetAdvantage, and ValueLine, among many others. I wouldn't pay for these separately (I can't afford it), but since they're already included in my tuition, it feels like I'm wasting money if I don't use them.

So go explore. You might find that you can save money by canceling your subscriptions or discover that you have access to something you've wanted to use but didn't want to spend money on.

Many public libraries have some or all of these resources available for their patrons, and many now have online database access from home. For example, the New York City Public Library has access to all of the resources listed above.

Pay a visit your local public library. You'll be amazed at what resources are available (and you're already paying for through taxes).


Ethical Investing Blog Carnival

This is the first of what (I hope) will be many blog carnivals on the subject of ethical investing. To me it seems there is a paucity of blog writing on this important issue. The blog carnival's purpose is to encourage more bloggers to write on the subject, and to assemble these posts in one convenient place for readers.

Below are three excellent submissions that were accepted, out of a much greater number (many submissions were off topic).

Hung Nguyen presents Socially Responsible Investment: Can it beat traditional mutual funds? posted at Meaningful Issues in Today's World, looks "at socially responsible investing (SRI). The idea is that by investing in socially responsible companies that you can improve your return. I quickly review the book The SRI Advantage and then look into the problems of SRI and why I won't invest in it."

Socks First presents CSR, Creative Capitalism and the Recession, exploring the following questions: "What's the future of corporate social responsibility? That's the unanswered question with the prospect of a bad US recession looming, threatening to take the world with it. Will companies continue to embrace it when they are battling for survival? Or will changing market conditions redefine corporate social responsibility."

Edith presents Prosperity is a Flow posted at Stewart Hsu, in a thoughtful post saying,"Money, like love, is meant to be circulated. See the value in having a conscious awareness of this balance between giving and receiving."

That concludes this edition. Submit your blog article to the next edition of Slackerwealth's Ethical Investing Carnival using our carnival submission form. Past posts and future hosts can be found on our blog carnival index page. Topics have to pertain to ethical investing. This could include, but isn't limited to, discussions of environmentally friendly, people friendly, animal friendly investments; what makes an investment "ethical," can it be profitable?, what commonly called "ethical" investments are anything but that?, is investing in the so called "vice" industry necessary unethical?, etc.