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Should You Ever Borrow To Invest In Stocks? Here Are Some Things You Need To Consider

Sounds too good to be true? Yes and no.

 

The idea seems like a no-brainer: you borrow money at low interest rates and invest it into high dividend yielding stocks. This way, you earn the difference on “free” money.

If this is something you’ve thought about or heard your family and friends doing and are thinking of jumping on the bandwagon, here are some things you should know.

Contra Trading

While technically this isn’t considered borrowing to invest, the concept is very similar. You buy stocks without putting down any money and hope to gain on price appreciation.

In Singapore, the settlement date can be up to T+3, which means you have to pay up for your trade on the fourth day after your purchase. Technically, you can “borrow” the trading limit on your account for up to four days interest-free.

If you sell your stocks by the end of the fourth day, you would have gained any profits, after deducting your trading costs, without having to put a single cent down. This can be powerful if you’re able to secure a high trading limit on your account. Or even amplify the effect if you’re using multiple trading accounts with different brokers.

However, this can be an extremely risky strategy. If the market turns against you, you have to be ready to either pay up for the stocks if you think it’s a long-term gem or bear the losses by the fourth day.

Typically, when we think about borrowing to invest, we actually take advantage of a brokerage firm’s margin financing account to borrow money and lower rates and try to make a positive gain on our investments.

Here are some of the pros and cons you can expect to face going this route.

Pros

# 1 Accumulate Returns On Money You Don’t Actually Have

When you embark on margin financing, you’re basically borrowing money from the brokerage firm to buy more stocks than you can afford with your own money.

You can only do this when you already have some collaterals with the brokerage firm – this is your current stock investments. Most brokerage firms offer between 2.5 times to 3.5 times leverage for your collaterals (cash and stocks).

The reason why brokerage firms may offer you an attractive interest rate is because your portfolio of stocks with them acts as a guarantee. In the event you cannot repay the interests or the loan, they will simply sell off your stocks to retrieve their money. Of course, any remaining amount will be returned to you.

Another factor that increases the amount of money you can borrow is the kinds of stocks you invest in. Generally, the safer your investments are deemed, the higher you may be able to borrow.

For example, if you have $20,000 invested in CapitaLand Mall Trust (CMT) units. You may be able to borrow up to 2.5 times this amount to purchase more CMT units – this means your investment portfolio will increase from $20,000 to up to $70,000 ($20,000 + $50,000 in margin financing).

Read Also: S-REIT Report Card: Here’s How Singapore REITs Performed In Full Year 2017

Trading at $2.02 today, CMT delivers a distribution yield of close to 5.5%. If we only invested $20,000, we would receive about $1,040 in distributions each year. Utilising the margin financing account, we can boost our distributions to $3,640. In addition, any price appreciation will also be magnified in our portfolio.

If we can secure a borrowing cost of under 5.5%, we will be able to earn distributions from money we don’t actually have.

# 2 Diversify Your Holdings

Another reason you may be tempted to utilise a margin financing account is to diversify your holdings. With $20,000 you may be able to just invest in a few companies, but with $70,000, you can invest in many more companies.

This may shelter you from idiosyncratic risks, or the risks that individual companies may have.

# 3 Provide An Alternative To Selling Your Current Holdings

To explain this, here’s a simple example. Imagine you own $20,000 in DBS stocks today. Tomorrow, you do some analysis and want to buy SingTel shares because you strongly believe it’s share price will perform well.

Read Also: 4 Interesting Stocks That May Do Well In 2018

If you do not have significant spare cash to purchase SingTel shares, you either have to pass up on the opportunity or sell your DBS stocks. If you want to hang on to your DBS stocks, margin financing can save you from having to sell it.

By putting up your DBS stocks as collaterals, you can receive another up to $50,000 to purchase SingTel shares.

The Cons

The pros provide a strong argument to embark on margin financing. But, don’t jump into in until you’ve read the cons.

# 1 Interest Rate Risks

When you’re borrowing money, you have to pay an interest rate on it. The same goes when you embark on a margin financing account.

The interest rate you lock in for your margin financing account today isn’t going to last forever. Some brokerage may charge as low as 2.9% in interest rates today, but against the backdrop of a rising interest rate environment, this may not last.

However, do note that the 2.9% interest rate is typically reserved for the safest investment grades. You may have to pay up to 6.5% for other investment grades. This too may rise.

# 2 You Have To Pay Interest Rates, But You May Not Receive Returns

Another way this may hurt you is that if you’re on margin financing contracts, you are obligated to pay the interest rates. On the other hand, the investments you make may not always deliver dividends or returns as you expect.

Imagine a scenario where you believe you will receive a 7% dividend yield on a stock, from historical calculations. There could be several reasons the company does not pay out this return.

  1. the company invests in new technology or machinery to stay competitive, using its cash reserves usually meant for dividends
  2. the company buys acquires another company, and uses its cash reserves usually meant for dividends
  3. the company does badly in the financial year and isn’t able to make similar dividend payments

There are many other scenarios, but you can see that the company may not be able to deliver expected dividends even if it is performing well. If you do not have cash reserves to tide through interest repayments in such situation, your investments may be liquidated by the brokerage firm.

# 3 Margin Calls

You should know that utilising margin financing means that you are using borrowings to amplify your returns. This means that if the stock market moves against you, your losses can be amplified too.

Losing your money isn’t the only worry in this case. Traditionally, if you invested your own money, any losses will mean that you have made a loss on your investments, and you can choose to sell your investments or sit on it to ride out the market volatility.

In the case of utilising margin financing, you may have margin calls being called on you. Here’s an example of how this may play out. Imagine you own $70,000 in Keppel Corp stocks, $20,000 of your own money and $50,000 by utilising margin financing.

In the event Keppel Corp stocks increase in price, you enjoy price appreciation on both your stocks and the $50,000 of stocks that you’ve borrowed to purchase.

In the event Keppel Corp stocks decrease in price, you suffer losses on both your stocks and the $50,000 of stocks that you’ve borrowed to purchase as well. The only difference is that margin calls come into play now.

In most cases, brokerage firms require you to keep a 140% margin ratio. This means you use your [ (value of own investments as collaterals today) + (value of stocks bought on collateral today) ] ÷ (amount borrowed). This works out to [ ($20,000) + ($50,000) ] ÷ ($50,000) = 1.4.

If stock prices go down by 5%, today’s value of your stocks bought collaterals as well as your own investments as collaterals go down by 5%. However, the amount borrowed remains the same. Here’s how the math works: [ ($18,000) + ($47,500) ] ÷ ($20,000) = 1.31.

This is under the 140% margin ratio required, and you will receive a margin call. This means you have to pump in cash or investments to bring the ratio back up to 140%. Failing to do so will mean part or all of your portfolio gets liquidated to cover this.

# 4 Additional Fees

Brokerages have an incentive to offer good interest rates for margin accounts, especially to good customers with deep pockets. This is because investing in such a method requires you to keep your stock portfolio in the brokerage firm’s custodian account.

Read Also: Custodian Account: What Are You Giving Up In Exchange For Lower Commission Charges

While you may enjoy slightly cheaper trading fees upfront, there may be extra costs fees, including management fees, dividend handling fees, corporate action handling fees,

# 5 Announcements Won’t Be Directed To You

This is a side-effect of utilising a brokerage firm’s custodian account. Doing so means that you will not receive any notification of Annual General Meetings (AGMs) or other corporate actions.

To circumvent this, you have to go through your brokerage firm.

Pros And Cons To Utilising Margin Financing Account

We’ve highlighted some pros and cons to using the margin financing account. Don’t be lured only by the notion of boosting your investment returns; there are many other pros and cons to consider before making this decision.