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Leveraging can lead to a bitter domino effect

Borrowing money to make an investment may not always be a good idea

February 06, 2022 10:26 pm | Updated 10:26 pm IST

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Businessman protects block falling, plans and strategies prevent business risks. Investment insurance business. Business risk control concept.

Whenever equity markets have been on an upward swing over an extended period, queries from TV viewers and print media readers tend to rise, too.

Some of them seek advice on leveraging. What is leveraging? Setting aside the dictionary meaning, leveraging, for a common man, means borrowing money to make an investment.

When equity markets show a rising trend, very often people borrow money and invest those funds in the stock market. Here, the thought process is that they will get to generate more returns than the interest they have to pay on borrowed funds.

Let us try and understand this with an example: Mr. Shah was approached by his bank relationship manager.

The manager offered Mr. Shah a loan against various shares, mutual funds and other investments held in his demat account.

The manager said, “We will charge you interest at the rate of 12% p.a.” Mr. Shah calculated, in his mind, that if he was able to generate returns of 22% on his investment in equity, after paying interest at 12% on his loan, he would make a net return of 10%. This was a good deal, again in his mind.

Illustration

Now, let us take a look at the same illustration with actual numbers. Firstly, a payment of 12% interest is certain. This is payment due to the bank, whether or not any return is generated from invested funds.

On the other hand, the return from the equity market is uncertain. If Mr. Shah is able to generate a return of 22% from his investment in equity, he will get a net return of about 10% in hand. This means that when other investors are enjoying a return of 22%, Mr. Shah will get only 10% returns. On the other hand, if the markets were to fall by 22%, Mr. Shah would lose 34% (the market loss of 22% + 12% interest).

When everyone loses 22%, Mr. Shah ends up losing 34%. So, his loss is more than everyone else’s and his gain is less than that of others.

Don’t get starry-eyed

Leveraging risk is extremely dangerous. Many a time, we unknowingly leverage risk in our portfolio. Here’s how: assume you have a home loan and pay your EMIs on time. When we have a surplus, instead of paying back more of the loan, we invest the funds.

Unknowingly, we are leveraging. In our balance sheet, on one side there is a loan and on the other side, there is a new investment. Often, people continue with their home loan thinking that they are gaining from tax benefits.

This is also wrong. As far as possible, repay the loan at the earliest. In 2008, when equity markets were on the rise, I remember advising many people to prepay their home loans. Most of them did, but a few who did not repay their loans repented in 2009. In 2009, the rate of interest on home loans went up, equity markets crashed and many had to face either pay cuts or a job loss.

Similarly, a situation occurred in the recent past at the beginning of the pandemic. Individuals with loans who faced pay cuts or who lost their jobs were more in stress than peers who were debt-free.

Luckily, this time, there is a simultaneous drop in the rate of interest on various kinds of borrowings but in any case, a loan is a loan.

Review balance sheet

Once you take on any kind of loan, look at your balance sheet. Are there any investments that can be liquidated to pay back the loan quickly? Particularly follow this advice if you have an outstanding home loan. Ensure that the house where your family lives is debt-free at the earliest.

Someone has rightly said, “Home life ceases to be free and beautiful when it is founded on borrowing and debt.”

Don’t ever leverage in life. Borrowing to meet basic responsibilities is understandable but borrowing to invest is a complete ‘No-No’.

Always be prudent and repay your loan, lay down the EMI burden and invest an amount equivalent to EMI in systematic investment plans (SIPs).

An equated monthly instalment (EMI) has an interest component, no matter how small. That interest contributes to someone else’s income. SIP is wealth creation for ourselves. We must use our hard-earned money for our wealth creation and not to boost anyone else’s income.

(The writer is a financial planner and author of Yogic Wealth)

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