Investing can be a great way to build wealth, but you need money to invest to get started. It’s the classic dilemma: before you can make money, you’ve got to have money. 

So, if you want to invest but don’t have the money, it may be tempting to take out a student loan or other type of loan to access funds. Then, you can simply invest the money, generate a return, and pay back the loan. 

Easy, right?

It would be easy, except for one of the core aspects of investing—risk. Every investment involves risk, and there are no guarantees that your investments will pay off. And, typically the higher your potential returns (like crypto or individual stocks), the higher the risk. So before you decide to take out a loan to invest the money, weighing the pros and cons is essential. 

Understanding The Pros And Cons Of Taking Out A Loan To Invest

Taking out a loan to invest is something you should carefully consider because of its potential benefits and drawbacks. 

On the one hand, taking out a loan can help you get money quickly and invest it right away. And typically, the sooner you invest, the better, as it gives your investments more time to grow and compound for the future. And given the incredible power of compounding over long periods, this can be a significant benefit, assuming your investment pays off over the long run. 

But there’s no guarantee that your investments will pay off, which could leave you on the hook for a loan with no money to pay it back. And depending on the type of loan you have, there may be no way out of it. For example, while some loans can be wiped away during bankruptcy, like personal loans and credit card debt, others, like student loans, are inescapable. So if you decide to take out a student loan and invest it in an altcoin that’s been hyped up by an influencer, and your money disappears, you’re left holding the bag.

“Let’s say you take out a student loan for $50,000 and decide to use 100 percent of that money to buy crypto instead of going to school, then all of a sudden, the alt coin you invest in goes under or the crypto exchange goes bankrupt, like many have done in 2022. What ends up happening is you end up not only losing all of your money, but you have to pay that back,” says Leonard Kim of AdvisorCheck. “Even if you have horrendous hardships and are unable to pay back the loan and think that bankruptcy might be the right thing for you to do, you can’t get your student loan dismissed either, so you will have to pay that loan back for the rest of your life,” Leonard continued. 

In addition, if you’re taking out a secured loan—putting up other assets such as your home or investments as collateral to qualify—you may be risking what you have and need for what you don’t have and don’t need—which, according to Warren Buffet, is something investors should avoid at all costs. That’s because when you put up another asset as collateral, you’re giving your lender permission to take the collateral if you cannot meet the loan terms. So, if you tap into your home equity to invest with the plan of covering the loan costs from your investments, but things go sideways, you could lose your home if you cannot cover the loan. 

Lastly, one of the most important concepts to understand when using a loan to invest is leverage—which can be one of the biggest benefits and drawbacks when considering this strategy. 

To understand leverage, it helps to look at a common example: buying real estate. When most people purchase real estate, they use a mortgage to cover a portion of the costs rather than buying the property with cash. This makes sense as properties can be very expensive, and most people don’t have that kind of cash on hand. But, when you purchase a property with a mortgage, you are essentially taking out a loan to fund part of that investment, which introduces leverage to the situation. 

And the thing about leverage is that it can pay off big when things are going good, but it can hit you hard when things are going bad.

For example, assume you buy a rental property with cash for $250,000. If the rental property increases in value by $25,000, you’ve generated a 10% return ($25,000 / $250,000 = 10%.) 

But, a more common situation would be buying the property with a combination of a cash down payment and a mortgage. So, assuming you put 20% down and finance the rest, you would put down $50,000 cash and have a $200,000 mortgage. Then, if the rental property increases in value by $25,000, you have just generated a 50% return on your money instead of a 10% return ($25,000 / $50,000 = 50%). 

That’s the power of leverage in investing.

But remember, leverage cuts both ways. Using the same example, if you buy the home with cash, and it drops $25,000 in value, you’ve lost 10% ($-25,000 / $250,000 = -10%). But, if you used some cash and a mortgage, that $25,000 drop would be a 50% loss ($-25,000 / $50,000 = -50%.)

So while using a loan to purchase investments can be tempting because it gets you invested quickly and has the potential for outsized returns due to leverage, it’s important to remember that leverage cuts both ways, some loans cannot be forgiven, and you could be risking what you have and need for what you don’t have and don’t need.

Consider Your Financial Goals And Decide Whether Or Not This Is A Good Idea For You

In addition to understanding the pros and cons of using a loan to invest, you must consider your unique situation and financial goals. 

If you haven’t already, take some time to list out your financial goals and priorities. Do your best to be specific by assigning a timeline and dollar amount to each goal. As you review your goals, ask yourself if taking out loans and investing the funds is necessary to achieve your goals. 

Of course, every situation is unique, but most people will find that they do not need to take out loans to invest to achieve their financial goals. And often, doing so just adds unnecessary risk and complexity to their financial plan.

By going through this exercise, you can better understand if your desire to take out a loan and invest is driven by an actual need or goal that you have or if you are simply experiencing FOMO as you see other investors having success in the markets. If it’s FOMO, keep in mind that other investors may not have the same goals and risk tolerance as you, and it would be unwise to model your decisions after them without knowing all the details of their financial situation.

All that said, if you go through and determine that you are interested in taking out a loan to invest, it’s essential to have a plan for the worst-case scenario.

Have A Plan For How You Will Repay The Loan If Things Don't Go As Planned

If you do decide to take out a loan and invest, having a fallback plan for repaying your loan is essential. 

It can help put you at ease, knowing that, even if the unexpected should happen, you have a path forward on how you will be able to repay your loan. Setting up an emergency fund or budgeting for extra cushion can make all the difference when it comes time to pay off the loan. Even better, talking with your lender and coming up with a repayment plan that works for both of you can provide peace of mind and keep your loan on track. 

Taking the time to prepare and plan can save you plenty of stress in the long run.

In addition, it’s essential to understand how investments are taxed when considering investing a loan. Generally, people assume that their investments will just need to earn a rate of return equal to the interest rate on their loan to cover the cost of the loan. So, for example, if you have a personal loan with a 7% interest rate, you might assume that you just need a 7% rate of return on your investment to break even. 

And that would be true if it weren’t for taxes.

However, when you earn interest or dividends on your investment, those will be taxed as ordinary income, at whatever your marginal tax bracket is for the year. Alternatively, if you sell some of your investments to cover the interest, those proceeds will be taxed as capital gains, either short-term or long-term, depending on the holding period.

For example, if you take out a loan at 7% and plan to sell some of your investments to cover the costs of the loan, you’ll actually need close to an 8% return to break even, assuming that your investments are taxed as short-term capital gains, and you are in the 22% marginal tax bracket. In other words, for every $100, you must generate close to $8 worth of returns to break even on your loan after accounting for the impact of taxes.

So, as you plan to pay back your loan, be sure to calculate your after-tax return to ensure you can cover the cost of the loan with your investments and have a backup plan to pay back your loan if your investments go to zero.

Lastly, Talk To A Financial Advisor If You're Still Unsure About What To Do

If you’re still unsure whether to take out a loan to invest, you should talk to a financial advisor. 

They're specifically trained on what works and what doesn't when it comes to money matters and can help offer advice tailored to your individual needs that might not be in line with general advice. Chatting with a financial advisor can provide expert guidance to help you make better decisions while offering an independent perspective on how best to approach investing or planning for retirement. Don't let indecision result in costly mistakes—take the time to consult with a professional who is well-versed in personal finance.

In the end, taking the time to weigh your options when deciding whether or not to take out a loan to invest is essential. 

It is important to always consider your financial goals before making any decisions, and talking to a professional can be incredibly useful in helping you stay on track. And if you do decide to take out a loan to invest, having the plan to repay it if things don't go as expected can help provide peace of mind. Lastly, taking the time to educate yourself so that you understand all of the details involved with this type of decision can ensure that you make an informed choice that aligns with your financial goals. Ultimately, ensuring you have done thorough research into this matter and taken the proper steps will leave you confident about your decision.

If you want to connect with a financial professional to discuss whether or not you should take out a loan and invest, consider making a free AdvisorCheck membership, then use our tool to search for a trusted financial advisor. They can help you build a plan that makes sense for you while maximizing the enjoyment you get from your money.

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Written by Anders Skagerberg, CFP

Fact checked by Billy Quirk

Reviewed by KJ Kim

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The information provided in this article was written by the research and analysis team at AdvisorCheck.com to help all consumers in their financial journeys, by providing the resources and the insights to help improve one’s financial health, make it through recessionary and inflationary periods of time, and save their earnings to use them towards building a secure financial future. 

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