Is it a Good Idea to Take a Personal Loan for Investments?

October 29, 2021 Mutual Fund

Nowadays availing of a Personal Loan has become a lot more easier than ever, mainly because the lenders are offering the funds digitally, which takes less than a few minutes to get ready-to-use funds in your account. A Personal Loan is an unsecured loan that can be availed without any collateral and can be used for almost every need in our day to day life. It is one of the most preferred types of loans, especially in young and mid-aged individuals. Many investors tempt to avail of a Personal Loan for investing in the equity market in order to time the market to earn maximum returns in a short duration. This article will further illustrate when it is a good idea to take a Personal Loan for investments and when it is not.

What is Personal Loan?

A personal loan is an unsecured loan that does not require any collateral and can be availed with minimum documentation. It is an easy way to get funds to take care of various personal and financial needs and can be repaid according to the terms and conditions. Since it does not require any security, the banks and Non-Banking Financial Companies (NBFCs) only check your credit score, credit history, and income while approving/rejecting your personal loan application. However, the rate of interest on a personal loan depends upon your repayment capacity and is very high compared to the other secured loans. It typically starts at 12% p.a. and can go up to as much as 28% p.a.

Why do investors consider taking a Personal Loan for investments?

Investing borrowed money in securities, such as stocks, mutual funds, etc. is called leveraging. There are two schools of thought when it comes to ‘leveraging’. Some investors strongly believe that leveraging is beneficial to earn higher interest in a short duration, whereas others believe that it is a highly risky affair.

Here are a few reasons why investors consider taking a Personal Loan for investments:

• No Restriction on the End-Use:

  Many loans come with a specific purpose for which the loan amount can be utilised. For example, if you take a car loan, you can utilise the loan amount only to buy a car and not for a vacation. However, there are no such restrictions on the usage of a personal loan. A borrower is free to utilise the personal loan amount for almost anything, as far as it is legitimate. So, you can use this amount for your child's education or wedding, home renovation, buying an expensive item, or investing it further to earn returns, etc.

• No Requirement of a Collateral:

  As personal loans do not require any security to back up the loan, there is no risk of losing the asset or collateral if you are unable to repay the loan. For example, if you avail of a Loan Against Property or Loan Against Securities, such as shares, mutual funds, life insurance policy, etc., then the lender holds the right and has the authority to sell your property/security to recover the due amount.

• Quick and Easy Loan Process:

  Investors usually require funds immediately, especially if they are investing in a stock market. In this case, Personal Loan can provide them with funds in a quick and easy way. Other types of loans require a property valuation, evaluation of a financial instrument, which can take time and can delay the loan process.

• Maximum Capital:

  More the money you invest, the higher will be the returns you earn. Therefore, many investors prefer to borrow money to earn the maximum returns in a short duration. A personal loan can be offered up to a maximum of Rs 50 Lakhs, depending on your profile and repayment capacity.

What are the cons of utilising a Personal Loan amount for investment?

Here are a few cons of using the Personal Loan amount for investment:

• Risk of Losing the Capital:

  There is always a risk that the money invested in stocks, mutual funds, Initial Public Offerings (IPOs), etc., or any equity related financial instruments might not generate expected returns or in the worst scenario, you might lose the capital partially or entirely.

• High Rate of Interest:

  If the rate of interest on the Personal Loan which you have taken is very high, then in that case you might not be able to earn sufficient income to clear the loan amount in the short duration of a loan. Furthermore, as personal loans are generally offered with a floating rate of interest, there is a chance that the interest rate can increase any time after availing of the loan.

• Short Loan Tenure:

  The personal loan tenure is typically one year to five years. If you are aiming for long-term returns, then you will not be able to repay the loan amount within the loan tenure. Moreover, with the high rate of interest and processing fee, the cost of a personal loan becomes very high, which is very difficult to achieve through investments in a short duration.

When is it a good idea to take a Personal Loan for investment?

Many NBFCs aggressively promote personal loans, saying that it is the best way to generate higher capital that can be used to earn maximum profits. However, banks and some NBFCs do not recommend investing borrowed money in risky investment options of short durations. Using a Personal Loan for leveraging may be a good idea only if your investment opportunity meets all these requirements:

• When you are strongly confident about your investment picks.

• When you are using your personal loan amount to invest in an opportunity that offers returns that are higher than the personal loan cost.

• When the returns are guaranteed or there is low/no risk of losing your capital.

• When the returns are expected in a shorter duration than the loan tenure.

• When you have a backup option to repay the loan, in case the returns are not as expected.

Why is it not a good idea to take a Personal Loan for investment?

As stated earlier, it does not make any sense to invest the borrowed money in risky investment options like stocks, IPOs, mutual funds, etc. While options like debt oriented schemes and fixed deposits, etc. offer guaranteed returns, they will not be able to generate higher returns to cover the cost of the loan. Therefore, it is a good idea to invest borrowed money only when you are strongly confident about your picks. Moreover, it is not advisable to invest your personal loan amount in small-cap or penny stocks as it will be highly risky due to their highly volatile nature.

Although it might make sense to invest the Personal Loan amount in some cases, there is a high risk associated with it and may lead to the following concerns:

• It Can Create a Huge Debt:

  Investing in the stock market itself is considered risky to some extent. And, if you are using the borrowed amount for it, then it will multiply your risk. Losing your own money can be disheartening but losing the borrowed money will leave you with disappointment along with a huge debt to repay.

• The Cost of a Loan Will Be Higher Than the Earnings:

  It is possible that you earn income from the capital raised by a personal loan. However, if you pay very high interest and a huge processing fee on it, then the cost of your personal loan becomes very high. So, even if you earn some profit from the investment in a short duration, there is a very low chance that it will be sufficient to cover the cost or earn income above the cost of the personal loan.

• Tighten Monthly Budget:

  If you have invested your loan amount for a medium-term or long-term, then you cannot expect any income from it in a short duration to pay your personal loan EMIs. If you have taken a loan, you are expected to timely repay it whether you earn any returns from it or not. Hence, if you do not earn sufficient returns, the EMIs will be an additional expense for you, which can make your monthly budget unaffordable until you clear your entire loan amount.

To Conclude:

While Personal Loans are easy to get, it is certainly not advisable to invest the Personal Loan amount into high-risk securities like stocks as it can turn out to be the biggest blunder of your life. You can consider taking a personal loan for investments only if you are confident that your investment picks will generate higher returns than the personal loan dues and they do not have high risk involved. However, make sure you are aware of the risk level and have a backup source of income to repay your loan amount in case you do not earn sufficient returns. Moreover, ensure that you do thorough research and compare the personal loans offered by various banks and NBFCs to get the lowest possible rate of interest and processing fee to lower the cost of your loan.

This article first appeared on PersonalFN here