Borrowing Money to Buy Stocks: Good or Bad?

Feb 26, 2011
J. Webster
Comments Off on Borrowing Money to Buy Stocks: Good or Bad?

Apple Stock

Is it bad to borrow money to invest in the stock market? Everyone knows the answer to this: you should not. Should not do it, as in never EVER do this. It’s the worst thing you can do, at least that’s what people say, people like Warren Buffett and Jim Cramer. People that know what they’re talking about. So they say.

The Risks

Why can’t you though? Why is it so bad? If I can borrow $20,000 at 0% interest through a few credit cards, balance transfer the money directly into my bank account, and then put that in to a TD Ameritrade account, what’s so wrong about that? You’re all set to go. Game on. You’re all ready to buy, buy, buy…You’re ready to get rich, rich, rich. Obviously it’s not that easy. There are of course tons of risks.

What can go wrong? Well, you could own Apple (AAPL), with all of your money in this one stock, no diversity, and then the market can crash. Yes, even a superb stock like Apple. And not just some wimpy correction, but crash, as in the great collapse of Lehman Brothers, Bear Stearns, AIG, and nearly the whole financial system. The world itself some could say or that’s how it felt a few years ago. We’re talking the gigantic sub-prime mortgage fiasco of 2007. That’s where you get into trouble if you’re borrowing money to buy stocks. And diversity, even owning some stocks that are accidentally high yielders, as Cramer would say, would not have even have saved you when the market gets smashed, as dividends can get slashed and then cut. Which happen to the dividends of banking giants like Wells Fargo and JP Morgan.

Picking Apple

Of course, Apple is a fantastic stock. So what’s there to worry about. Perhaps the greatest stock in the history of the stock market. Going from a price of $10 in 2000 to $350 in 2010. Now they have 50 billion dollars in cash and the Mac, the iPhone, iTunes, the iPad, music in the cloud, and they might even develop a TV in the future. They’re just a juggernaut of a company that’s not going away. What if they’re able to make inroads in the professional market – sell more Macs on the enterprise front. What if businesses start to use Apple computers instead of PCs? There is nothing to worry about. Apple stocks is only going up, up, up.

However, when you borrow to invest you can get stuck and have to sell the stock to pay off your loans that will soon turn to interest rates of 10% or even 20%. That’s the rub. And then what if you miss one payment, just accidentally, having the money but forgetting to pay on the right date. There goes your low interest rate. It could then soar to 30% and you’ll also be charged a late via, which could then push you over your credit limit, resulting in another fee. What’s worse though is this will destroy your credit score and you want be able to borrow money at a low interest rate for some time.

Plus, a stock like Apple has no dividend. There’s no cushion or reason to hold on to the stock if the financial market seems on the verging of falling off a cliff. The big players and hedge funds sell the stock hand over fist, especially since it requires a fair amount of capital to buy the stock, since during the crash it was close to $200 a share late in 2007. It is those ‘player’ stocks, those high flyers, that go down first and fast, as in dropping to nearly $80 dollars a share in January of 2009. As they say, “Stocks take the stairs up but the elevator down.” All you hear is the sound wooosh, the door slamming on your stock after he lives it’s once high price. Even Apple, with all their cash on the balance sheet.

Monkey on Your Back

If you borrow money, especially via credit cards, then you are always trading with the loan on your back, a monkey on your back, so to speak. This monkey can influence your trading strategies. You might start to panic and make impulsive, rushed trades with the idea that you have to earn the money back before your 0% interest rate goes away.

But don’t all companies borrow money to invest and make more money? Don’t all companies get financing at a low interest rates and then use that money to make things they can sell and make more money? Yes, but they have a business that makes money, so they can pay back the loans. They have cash flow.

However, despite all the risks, for me, I don’t see anything wrong with borrowing money to invest in the stock market. But you must have a back up plan so you don’t get caught in situations where you need to sell stock to pay off debt as the interest rate adjusts. That way you can keep Apple’s stock and ride what became known as the great recession. That way you can hold on to your stock and see AAPL reach $400 a share in the coming years.

Back Up Plan

The back up plan should entail even another credit card that will allow you to do a balance transfer to pay off the debt and give you some more time. Or is there someone who can loan you money, just in case? Explain to them what you are doing beforehand. Tell them what stock you are buying. Show them you’re not buying some penny stock or a risky company that hasn’t even made money yet. Show them how you are buying a company that has loads of cash and some of the best products in the world that everyone wants.

Focused

And, you have to stay steely eyed in your focus. If you believe in the stock you borrowed money to buy, as in this case with Apple (AAPL), they you have to weather the storms and almost not watch CNBC or read all of the headlines about how much trouble the market is in. If you believe the stock is going to $400 then you have to have a lot of patience, and not sell even when you see a huge gain over the course of a few months. In many ways, it’s like the Buffett strategy, where he buys stocks for life. Also, with Apple, you have be able to handle the worry that Steve Jobs will one day step down. Does this change your thesis about the stock? If so, then you have to be prepared for when they day comes.

The point is if you borrow money to buy stocks that you have to imagine the worst and prepare for it. You don’t want to be in a position where you might panic.

For me, it’s like how is someone supposed to get ahead if they don’t borrow money to invest? If it’s done right, with a plan and a back up plan, I don’t think borrowing to buy stocks is a bad thing.

It’s All About Timing

Really though, and ideally perhaps, the key is all about timing. If you borrowed money to invest in the stock market just after the crash, when Apple went down to $80 a share, well, that’s just genius. If you can borrow money at no interest and scoop up a bunch of good companies who have been cut in half, that seems like a no brainer. If you can buy companies who are all of a sudden yield upwards of 6% to 8%, then that’s just smart.

Stay in the Game

What if you borrow $20,000 and then buy more stock on margin. Are you asking for it when you do that? That’s another story. That’s a lot of leverage. But isn’t that what the big hedge funds do, use lots and lots of leverage to make money and get rich. Well, yes, but this gets us to the idea of staying in the game. And that’s getting greedy and greed is not good, despite what Gordon Gekko might say in the movies. If you borrow on margin and are already borrowing in the first place, you can easily get wiped out and kicked out of the game entirely. Which means you have zero money to trade and try to make your money back. The game is then over.

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