Reader Mailbag
December 3, 2008 – 5:36 amI get questions via email on occasion, and when I get a question that applies to others I like to post the question and my response (both edited for brevity).
Question: I’m 32 years old, and I’d like to know if it it worth borrowing money ($3,000 – $5,000) from my credit card to max out my Roth IRA this calendar year if I know I could pay off the borrowed loan within 1 to 2 years time at a relatively reasonable low or fixed interest rate (say 7%)?”
I ask this question because I realize I won’t be able to borrow money for my retirement when I’m older, and the compounding effects of early investment even if they the money I made in stocks gains was canceled out by the fixed rate loan while I paying it during the 1 or 2 years of the having the loan – seems worth the future investment compounding and growth opportunity if I’m looking at a 25-30 year horizon.
I’ve maxed our my 401K match so am looking for next investment opportunity. My basic plan is to pay myself back during April 2009 when I get my tax refund, but I’m curious even if i didn’t pay the loan off in 1 or 2 years, would it be worth it – statistically speaking?
The main question is a common one: should you borrow to invest? No. That’s the short answer. On paper, of course, it can make a lot of sense, but in the real world it’s actually RISK that you’re taking on. The markets don’t go up at a steady clip year after year. If you could borrow at X% and invest in something that would return (X+Y)% every year, then we would all borrow every penny we had and invest it this way. Of course if you did this with the stock market this past January because the market returns “10% a year” (on average), you’d have experienced a 40% loss and would still have the interest to pay on the borrowed funds.
Here are a few more thoughts:
- 7% is not a “low” interest rate. I actually had a student loan at 1.75% a few years ago and I decided to pay it off rather than invest the funds. I knew on paper that investing it would provide a better return, but I was taking on more risk than I knew. With hindsight being 20/20, this ended up being a good decision.
- If you really want a low interest rate, why not borrow more on your home? The interest is deductible (usually), which reduces your effective interest rate. Very few people with a paid-for home would take out a mortgage just to have more money to invest. The wealth and security that such money would give would be fake and worthless.
- If you have a 20-30 year investment time horizon, an extra $3000 to $5000 investment now will not make that much of an impact, especially if you’re able to invest a lot each year. This person said they maxed out their 401k for the year. I sent back a question to clarify this, because I wanted to make sure they really did invest the $15,500/year federal maximum. If you really invest $15,500 a year, and extra one-time investment won’t make that much of a different either. If “maximum” means “I invested enough to get my full employer match”, then it may be a different story. I still wouldn’t borrow to invest though.
- It’s interesting that we all tend to think of the “easy” ways to make money and are rarely willing to do the hard things. This is more true of me than anyone. Borrowing to invest is “easy”. Reducing our expenses in order to save more is hard. It’s no surprise that I never receive questions about whether someone should reduce their spending and invest the difference.
Thanks for the questions, and keep them coming. As always please remember that I’m not a financial adviser, so you need to make your own decisions based on your own situation. I’m happy to give my opinion on a hypothetical situations though!
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