Is it a good way to create wealth? Joseph Samson has the answers

Most of you borrow to buy a car or a house, but have you ever thought of borrowing to invest? Borrowing to invest is known as leveraging. Most of the financial planners advise their clients to use leverage to invest, emphasising that it is a good way to build wealth. But this might not be entirely true.

Relying on their financial planners, most of the people go for these leveraged investments. However, you should take care of a few things if you want to invest using leverage

Be careful while borrowing

Things have changed drastically since 1999 when the loans were very cheap. There were loans available for almost everything resulting in a decline in personal savings rate and increase in the debt payments as a percentage of disposable income.

Brokers were making more money than the total wealth created by all the investors. In the United States there was nobody to put a check on the leverage-based home loans. There were loans for NINJAs (the No Income No Job Applicants) but in India, banks were reluctant to grant minimum loans to people with minimum incomes.

Today, after the global financial crisis, lenders have become more wary. It has led to introduction of stricter rules in the system and a more responsible outlook of things.

Before using leverage for investing, you should decide whether you need to borrow or not. However, it is equally important to understand that there could be good reasons to borrow for your child's education, for buying a new house or a car. If you borrow for such purposes, you should make larger down payments in order to reduce your debt. You should not borrow unless there is a desperate need.

Consider the total cost of borrowing

After the collapse of Lehman Brothers and Bear Sterns, more and more banks and financial institutions began to fail, dragging the global economy in the worst ever crisis. Therefore you should keep a close watch on your cost of borrowing.

Not repaying debts can really make things complicated. Your builder might come across similar problems with his investments and borrowings, thus compelling you for early instalments. This can also take place at your office leading to layoffs by your employer to pay off his debt. Therefore before borrowing, each one of us should reckon the cost of borrowing and then decide accordingly.

Points to keep in mind while borrowing to invest:

• There are certain points you need to be careful about while borrowing to invest.
• You should always be conservative about using debt for investment purposes.
• You should manage your debts more wisely by making more down payments, thus reducing your borrowings.
• You should choose the right kind of investment.
• Do not borrow to buy a car since car is a depreciating asset.
• Do not borrow even for buying a house for yourself since it is an illiquid asset; if you need money in future you cannot dispose off your own house quickly.
• Instead invest the borrowed money in mutual funds. A mutual fund is a diversified and liquid asset with potential of capital appreciation in the long term.
• Never say yes to home improvement loans as they do not make any sense. You should spend on consumer durables out of your own income.

Illustration: Uttam Ghosh/Rediff.com