When Borrowing Money To Invest Could Make Sense

This week’s post is a guest post from Loui who is a fellow Danish FI blogger I have been in contact with over the past year. He recently launched his blog and has many interesting takes on FIRE and other things personal finance-related. Today’s post is a controversial topic of borrowing money to invest, and I am not sure I would do it myself, but I do follow Loui’s arguments and thinks that the FIRE community needs new provocative ideas once in a while 🙂

At Wannabe Walden we are searching for how we can retire as fast as possible. We all know FIRE is to calculate how much you spend annually, and multiply that by 25, and avoid debt at almost any cost. This is good advice for a lot of people.

But we want more at Wannabe Walden.

We don’t want to spend 10+ years to be free. We want to free as fast as possible. We are talking about 5 years or less.

It is an untraditional way of looking at FIRE, but I guess we are a lot of untraditional people out there.

Here is how we are going to do it.

Stop Striving

I have been sold a dream. A dream that wasn’t mine. But for many years I thought it was. The dream was to get an education, and then start a huge successful company with hundreds of employees. I should drive in fancy cars and own a huge mansion.

I was 21 years old before I had finished my first book ever. I realized back then I could learn something from the best minds in this world. I started to study how the rich made their money. Because that was what I wanted, to become rich.

There seems to be a pattern when it comes to humans, money and dreams. If you have a decent place to live, and healthy food to eat, you don’t feel fulfilled. You will never feel satisfied.

It has a fancy name called hedonic adaptation. It means that you adapt to everything that gets thrown at you, good or bad. You all know that feeling of how the next single purchase is going to change your lives. But it never does. And it never will.

It is a powerful feeling when you realize that almost nothing besides shelter and food is a necessity in this life.

Everything else besides that is a splurge. No single purchase is going to have a long-lasting effect on your wellbeing.

Simple Living

When you have realized you don’t have to take part in the culture of never-ending promotions and late nights at the office, you can start to fill your lives with what matters. Like socializing with the people you love. Taking on projects that you feel like doing, and not for the sake of money. Go where ever you want on this planet. With no ticket “home”.

Being humble about the stuff you own has several advantages:

  1. There will be less maintenance. For every purchase you make there is an equal amount of maintenance. If you buy an expensive bike, the cost of the maintenance will be greater than if you buy a cheaper one.
  2. You will have more flexibility. It will be easier to clean your home. Easier to travel. Easier to move.
  3. Less stress.
  4. More friends and deeper relationship with existing ones.

The three biggest expenses we have in our lives are:

  1. Housing
  2. Food
  3. Transportation

Housing

Being humble about these areas will make you a FIRE super rocket. And it is way simpler than you would think. Simple things are often powerful, but they can be mundane and boring.

Many people are born and raised with the idea that renting is throwing money out of the window. This is true if you are not able to invest on your own. But if you can take the money you would normally spend on a mortgage and invest in a low-cost index fund, you would be better off in the long run. However, most people don’t have a deep desire to invest for the long run.

Renting a place or buying a smaller home and investing the leftover money instead could move you closer to FIRE than buying what you would call a “normal home”.

Food

Being humble about food is also way easier than you think. You could eat out less often and choose simple dinners instead of fancy 5-course meals. I love well-cooked food, and I love the luxury of other people cooking for me. I would rather pay for a delicious expensive dinner once every third month, than pay for some mediocre meal I could have prepared better myself.

Eating less meat is also a super way to help save the planet, your health and your wallet. You don’t have to stand on a mountain top and claim to be vegetarian. Start to see meat as a treat and eat an organic/well treated animal when you do decide to eat meat.

Transportation

Transportation can really make me laugh. When people complain about their finances and still see their new car as a human right. Ditching your car and getting a second-hand bike is the fastest way to cut this expense to almost $0/month.

“But I can’t bike 12 km to work every day?!”

Of course you can! Again, you will help save the planet, your health and your wallet by biking. I would claim this post is the easiest of the three to implement. And as with anything else, you will adapt to that 12 km trip. Heck, you might even end up enjoying it.

FIRE on steroids

When you have looked at your housing, food and transportation expenses, you know exactly what amount you need monthly and yearly. The normal FIRE way would be to multiply this number with 25. Also known as the 4 % rule.

I see the 4 % rule as ridiculously conservative.  

If you are just a bit flexible on what you do when you quit the normal 40 hour/week job, you can withdraw as much as 7 % according to several studies. This means you can take your annual spending and multiply by 15 instead for 25.

But it gets better:

If you are young (and by young, I mean 40 years or younger) it can make sense to leverage debt.

Yes, you got that right.

Borrowing money to invest.

Why leveraging short-term can make sense

Let’s say that you earn $4,000/month and spend $1,400/month or $18,000/annually on housing, food and transportation. You decide that you want to quit your day job as fast as possible, so you are aiming for an SWR of 7 %.

This means you need to hit: $18,000 / 7 % = $260,000  

Let’s assume you have a monthly savings rate of: 65 %  

If you are conservative and say that you will not have any ROI on the money you are investing, you will hit that $260,000 in 8.5 year.

But the power of FIRE lays not in how much you are making, but in how much you are saving! This is where the power of leverage comes into the picture. If you leverage 2:1 that means for every $1  you are investing, you are borrowing another $1 and invest that as well.

Now you have reduced your working period from 8.5 years at the desk, to 4.25 years. Without any form of return on your investment.

This means that if you read this post as a 21-year-old, you could be retired by your 25th birthday.

Why leveraging long-term can make sense

Let’s imagine you have read the text above and decided leveraging is not for you. Instead you do it the traditional way and dollar-cost-average into the stock market. Doing this from a young age means you have very little money in the market when you are young, and a lot of money in the market when you are old.

If you invest $10,000/year, and get 7% ROI + 2% inflation from age 25 to age 65, this is how your wealth will increase:

2% of your wealth is created between the age of 25-34. An astonishing 64 % of your wealth is created between age 55-65. This also means that you are super exposed late in life, where you don’t have the time to make up for a bad period.

People often talk about bad years. But bad decades occur too. From 2000-2009 the S&P 500 made nearly no return for investors. And how do you think your portfolio would look, if you are expecting to make 64 % of your wealth late in life, and you end up with a decade like that?

“All right. Maybe I want to leverage while young, but what do I do with the $130,000 of debt?”

If you look at a 40-year Monte Carlo simulation on how a $260,000 portfolio would have performed with an annual withdrawal of $18,000:

The 50th percentile of a 100% stock portfolio diversified across the whole world would be around $2,200,000 and adjusted for inflation you would have $800,000. This is way more than the debt of $130,000.

In the scenario above, you are not making a single dollar more in your life. Let’s imagine you can make $4,000/year on some sort of business you enjoy doing. Then you only need $14,000/year from your portfolio.

If you run another Monte Carlo situation on the $14,000 withdrawn from a $260,000 portfolio for 40 years, the numbers will look like this:

The 50th percentile on a portfolio like that would end up at $3,300,000 and adjusted for inflation it would be $1,200,000. Just for having a small business where you make $4,000/year.

It’s not for everyone

A plan like the one I described is not for everyone. If you are at all in doubt about how you are going to react when the stock markets crash, it will not be for you. For this plan to work you must be ice-cold when the shit hits the fan. Because it will.

Having said that, borrowing $100,000 while you are young to invest is not that much money compared to your total life net worth. Without earning another dollar in your life, you are likely to have a $2,200,000 portfolio after 40 years of investing. So those $100,000 you borrowed ends up being only 5% of the total amount.

The rate that we are borrowing at is of course very important. As a rule of thumb, the stock market average about 7 % over the long-term. So if we are borrowing money above 7 %, that will not be a very good deal. I’m fortunate that I have margin account on my investments. Where I can borrow for 1-2 %. If we can borrow money for 1 %, inflation is going to work for us. Because the typical inflation is higher than 1 %.

And no, it will not be a smooth ride. You will need to remain flexible during the journey. Maybe you will end up working a year or two longer than expected. And maybe you will need to work a couple of years into “retirement”.

The alternative is to do what the majority do. Work at a job for the rest of your life with 5 weeks of vacation. If you are lucky.

You could also choose not to leverage your investing.

You need to be excited to chase financial independence and not let fear hold you back.

Instead of seeing it as the day you stop working, think of it as the last day you do mandatory work. This is because you have a financial cushion.

It will be the first amazing day in the rest of your life.

4 comments

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4 comments

Route2FI January 23, 2019 - 14:35

I use leverage for my investment as well.

In august 2018 I used leverage/gearing to buy index funds for aprox. 35.000 $. I now got 140.000 $ invested in index funds, this means that my portfolio is geared by only 0,35.

The interest rate I got for this stock loan is 2,19 %, and that’s really low. I’m letting the inflation “eat” up my loan costs. And as long as I expect 7 % annually interest rate for my index funds, I consider this as a good choice.

Criterias for leveraging my index funds
To get 2,19 % interest rate, I have to fulfill some conditions in my brokerage account:

-My funds has to be diversified, but none of my index funds can contain over 60 % of the total value. (The biggest index fund I have to this date is 48 % of the total).

-The stock loan has to be lower than 40 % of my total loan value (the loan value is 80 % of total value). My current stock loan is 30,5 % of my total value.

If I meet these criterias (which I do), I qualify for 2,19 % interest rate. If some of the criterias isn’t met anymore, I’ll head up to 4,44 % interest rate.
So if I’m going to leverage my portfolio more than 0,3 i have to pay a higher interest rate than 2.19 %.
Where do you get 1 % ? I use Nordnet btw.

Reply
Carl Jensen January 25, 2019 - 10:26

Very interesting! It’s of course a higher risk strategy than not leveraging your investments, but the upside is bigger. Who did you get the stock loan from and how did they make those criteria? As long as you meet those criteria, I believe it looks fairly attractive, but if you get up to 4.44% then you could be in for some trouble (or just low returns).

If I were to leverage my portfolio, I would get a Danish “realkredit” loan to get an interest rate of 1% if you own real estate and have some “friværdi”.

Reply
The Beta Post September 22, 2018 - 20:27

Great post! I’ve actually leveraged my portfolio since I believe the interest rate is way below the expected long term growth of the market. You can read my post about it here: http://thebetapost.com/why-I-use-gearing

I’ve calculated that I can make 1.1% more a year by using leverage wisely. But like you say, it does increase the risks. A decade with negative or about zero returns will effectively ruin that number.

Reply
Carl September 23, 2018 - 10:09

Very interesting, TBP! I like your way approaching it 🙂 I am not sure I have the confidence in the global economy today to take on extra risk, but I do think it can be a valid strategy for some people.

Reply

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