Personal loans can be used for a variety of purposes.
They can be used to start a business, carry out home repairs, consolidate existing debt or meet an emergency expense.
However, personal loans can also be used to invest, enabling us to build a portfolio over time.
This article looks at factors you should consider before committing to taking a personal loan to invest.
Though it is tempting to use a personal loan to invest, there are critical factors that you should consider before making such a decision.
One of the most important factors you should consider is interest rates payable on the loan.
The interest rate determines how much profit you are left with after you make loan payment deductions. Since interest rates take chunks off your profit, you should strive to get the lowest rates possible.
The amount of interest payable on the loan is determined by your credit score and benchmark interest rates. If you have a poor credit score or interest rates as set by the Federal Reserve are high, then using a loan to invest is not a good move.
The time it would take you to repay back the loan is another critical factor.
The longer the tenor of the loan, the more you pay in interest. However, it can also give you more flexibility on how to use the loan. It reduces pressure and allows you to take on more risks, which can increase returns on investment.
As such, time works as a double-edged sword when using loans to invest. If you can, it is better to pay off the loan early. If you prefer to use a loan with a longer tenor, be sure to compensate for the extra interest by trying to increase your returns.
Also, find out if you can repay the loan early and if there is a prepayment penalty.
Never take a loan to invest unless you can properly estimate the returns you would get on the investment.
An estimation of potential returns enables you to know if the loan is worth taking, especially when you factor in interest payments.
However, estimating your returns is steeped in probability, because you can't properly forecast the economic conditions that may happen within this period.
For example, if you took a personal loan to invest in February 2020, you would have suffered heavy losses the next month when the stock market plunged by 30% in a single day. One way you can bypass this occurrence is by giving margin or error.
Try to estimate how much loss you can take.
Before you take a loan, always consider how you would pay it back.
If you are using a personal loan to invest, then you should pay more attention to this factor. You have to recognize that you can lose the capital invested. As such, you need to come up with a contingency plan to help you fulfill your loan obligation if things go south.
Estimate how much you can afford to pay monthly over a specific period. One way to do this is to keep part of your loan to service the debt until the invested portion starts to yield returns. Alternatively, you can keep some part of your income which can be used to service the loan.
While focusing on the interest rate and how you can repay the loan, do not lose sight of the fees you would pay for investing.
Certain investments attract higher management fees than others. You can also accrue fees through commission payments to your broker. When added up, this would reduce your profit and could significantly impede your ability to repay your loan.
If you are considering investing in stocks or ETFs, you may want to use a broker that charges $0 commission fees.
Taking out a personal loan to invest is a high-risk strategy.
You are trying to use debt to generate more returns while paying interests and other charges. Also, the investment may not yield expected returns, plus you could lose the capital invested. As such, this requires a huge appetite for risk among other factors.
Your risk level would also determine what type of investments you would want to participate in. If you have a conservative approach to investing, then you shouldn’t be taking out a loan to invest.
Interested in investing? Read this next! Top 10 Goal Based Investing Habits You Should Copy Right Now
Taking a private loan to invest may not be the ideal way to achieve financial independence.
However, if done properly, it can be a gateway to building a solid portfolio of investment. It is important to evaluate the potential rewards against the risk involved before you commit to taking a personal loan for investing.
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