How much money you borrow, when you do so, and how you choose to repay the loan has a huge effect on your overall financial wellbeing. So whether to borrow to buy an asset is a significant decision, and it’s important to think about your reasons for using a loan.
Borrowing to purchase an asset will come down to being for one of two reasons:
- To overcome a problem with timing of cashflow; or
- To speculate on the growth of an asset.
Although we don’t usually think about the decision this way, borrowing to overcome cashflow timing problems is the reason we borrow quite frequently. The common example is purchasing a home to live in.
Because the cost of a house could be anywhere from 3 to 10 or more times our disposable income, we’re not normally able to just purchase it straight from savings. So we take out a home loan, and spread that purchase price out over a much longer period of time such as 25 years. Your bank of course doesn’t lend you the money for free, you pay interest for the privilege!
What we’re essentially doing here is taking the purchase cost of that house and spreading the cashflow impact out over a large number of years. This is significantly different from the second reason for borrowing.
Speculating on growth
Another reason people borrow is that they want to purchase an asset as an investment because they believe it will earn strong returns. They are borrowing because either they don’t have the savings available for the purchase, or the savings they have they want to keep available for other purposes.
When you’re borrowing for this purpose, it’s important to understand that for the investment to be successful, it needs to provide a positive return but that return also needs to exceed the costs of your loan such as interest and any other administrative expenses. While it might look quite similar, this type of investment is significantly different to saving and investing your own capital.
Even with rates at quite historically low levels, there’s no guarantee that speculating on the growth of an asset will provide a positive return, and when you’re using debt there’s a greater potential for loss of capital.
It’s important to distinguish between your reasons because it will mean you have quite different definitions of success for your purchase. If your end goal is just to own a certain investment portfolio, and you’ll be paying the principal down on your loan over time, lower returns from the asset will mean your investment returns aren’t necessarily through the roof, but you could still have met your goal of owning an investment portfolio or property, so the borrowing and purchase have been a success.
Contrast this with an investor who was only ever speculating on growth in the value of the asset. If their asset doesn’t grow, or doesn’t grow enough to offset the interest costs then the exercise clearly hasn’t met its goal and can’t be described as a success. Speculating successfully is definitely more difficult to achieve than the alternative of gradually paying the principal down on a loan.
So before you take out the loan – first ask yourself what your goal is and then you can work out whether you think the odds of success are strong enough for you!