When Does Investing with Debt Make Sense

The bank I use for my savings account has been pestering me for the past few months to borrow money, and every time they pester me, they keep increasing the pre-approved loan amount and also reduce the interest rate.

Right now they’ve just made an offer of pre-approved loan amount of $237,000 (HKD) with APR of 2.99% for a repayment period of 24 months.

To be frank, 2.99% APR is very enticing, cause I keep thinking to myself, “I could generate ~10% return just by solely actively managing index funds, 2.99% is nothing”.

But whether investing with debt makes sense can only be done after understanding the nature of debt, and my current cash flow and cash reserve situation.

The nature of debt makes 2.99% APR look too cheap.

With investing with debt-free cash, it’s like building a house on a solid foundation, the house building (time needed for investment to materialize profits) being the potential returns from your investment and the solid foundation being the principal. By the end of your investment cycle, you hopefully can salvage (sell) not only the built house (potential returns) but also your solid foundation (principal).

But when you invest with debt, it’s like building a house with a sinking basement, the sinking basement being the principal and debt you have to repay the loaner over time and have to use debt-free cash to pour into the sinking basement to keep the foundation solid so that the house building can continue.

The reason why you need to shovel debt-free cash into the sinking basement is because lots of investments require 1-3 years in order to materialize profits, so you’ll have to have cash flow or cash reserves be occupied by debt repayment until the investment can materialize full profit to repay debt or re-fill your cash reserves. Any pre-mature salvaging of your house building would most likely yield less than optimal results, which defeats the purpose of having to borrow money to invest in the first place.

So when thinking about debt repayment, you should consider whether you have enough cash flow (and if not, cash reserves) to service principal repayment so that your investments’ returns can service interest rate repayment.

For cash flow, if I did borrow the full $237,000 as pre-approved, I’d have to repay the bank $10,119.9 monthly. I’m frugal, but even I couldn’t finance that kind of monthly repayment schedule from my monthly income alone. Even if I only borrowed $100,000, which is the minimum needed to keep interest rates at 2.99% on a 24 month repayment schedule, that’s still a monthly repayment of $4,270.0. Sure I can afford it now, but what if I lose my job? What if rent rates hikes? And if I have to repay by dipping into my cash reserves, why wouldn’t I invest with my cash reserves instead, which is interest-free in the first place?

So if I do borrow to invest, then I have to make sure I can service debt repayment with my current cash flow, but also prepare cash reserves just in case my cash flow does fail on me in the future, and the only time it makes sense to invest with debt instead of investing with my cash reserves immediately, is when I want to capitalize on an investment opportunity while maintaining enough liquidity in my emergency reserves, which for me is 18 months worth of expenses.

As for at most how much I’m willing to leverage, the answer is debt-to-equity ratio of 1.0. When I analyze companies, the most I can accept for debt-to-equity ratio is 1.0, so the same should be applied to my own personal finance. What the debt-to-equity ratio of 1.0 implies is that I have double the assets to my debt, since equity is assets minus debt, so if my assets (eg. investments) drop in value by 50%, I can still theoretically service my debt repayment if my cash flow can’t.

So if I can’t service debt repayment with my cash flow or have more than 1.00 debt-to-equity, I can forget about borrowing money to invest even if it’s offered at attractive APR rates.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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