Here's Why It's Dangerous When You Borrow Money to Invest

The stock market has been doing very well lately. The S&P 500 went up by 24.23% last year, and it has kept growing so far in 2024. And any time the market is delivering positive returns, investors start wondering: Why don't I borrow money to invest?

Seeing your portfolio grow is nice, but maybe you don't feel like it's good enough. Everyone wants to boost their returns, after all. So instead of just using their own money, some investors borrow money. It's often a decision that leads to disaster.

Borrowing money to invest: The basics

The most common way to borrow money and invest is with margin. Margin is money you borrow from your stock broker. To do this, you need to open a margin account. A cash account, on the other hand, only lets you invest your own money. But it's not hard to open a margin account -- you only need to deposit at least $2,000 to meet FINRA's requirements.

Many stock brokers offer margin accounts, which typically double your buying power. If you have $10,000 of your own money, you can borrow and invest another $10,000.

The other option is to take out a personal loan and invest with that. Investors generally stick to using margin, but some do ask about getting a loan. With interest rates the way they are, this would be expensive. The average personal loan rate is 12.17%, according to research by The Motley Fool Ascent. That's more than you can realistically expect from any investment. You'll also need to make loan payments every month, whereas you can normally repay margin at your own convenience.

The dangers of investing on borrowed money

When you borrow money to invest, it multiplies your gains or your losses. Investors who do this are an optimistic bunch, and they usually focus more on the first part.

Your investments could just as easily lose value. The stock market is volatile, and there's no predicting what it's going to do from week to week. You could find yourself losing money on your investments while still needing to pay interest on the money you borrowed. And interest rates are high right now -- many brokers have margin rates of 12% or more.

If the value of your investments falls too much, it can trigger a margin call. Your broker isn't going to risk losing the money it lent you. When your portfolio's value goes below a certain threshold, you'll get a margin call. That means you need to either deposit more money into your account or sell stocks to pay off your loans. If you don't do either, your broker can sell stocks from your account itself to cover the loans.

It doesn't matter if you're sure your investments are going to bounce back quickly. It doesn't matter if everyone's portfolio took a hit from a global pandemic. If you get a margin call, you could be forced to sell at a loss.

Investing is better than gambling

The age-old wisdom about gambling is that the house always wins. When you use margin, you're gambling, and your stock broker is the house.

It's a great deal for your broker. You're paying interest on what you borrow, win or lose. Your broker can always liquidate your positions if necessary -- and if it's not able to recover its money that way, it can sue you.

The borrower, on the other hand, is betting on their ability to time the market. No one can reliably do that. Some investors get lucky and make money, at least for a while. But even the ones who have initial success often end up losing money eventually.

Regular investing is boring. That's a good thing. Boring is safe and reliable. If you invest $1,000 a month of your own money for 35 years, and get an 8% annual return, you'll end up with $2.07 million. It may not be exciting at the beginning, but you also won't have the stress of interest piling up and possible margin calls. And it gets a lot more exciting once you see how much your money is growing.