I’ve recently been thinking about some thingsÂ related to my own personal finances in regards to taxes, investing, and debt pay-down. Over the next couple months I have quite a few important decision to make. All of this thought got me to thinking about the idea of borrowing to trade or invest. It’s a subject that comes up from time to time among market participants.
Borrowing for Trading
For the record, I’m not generally a proponent of borrowing to fund one’s trading. This isÂ especially trueÂ if you don’t have sufficient non-trading income or resourcesÂ to pay the loan back if the trading doesn’t produce the anticipate performance. The risk of disaster is too great.
You do not want to be in a position where you take some trading losses and cannot make the requisite loan payments. That’s a quick way to destroy your credit and/or personal relationships. It’s really easy to get caught up in positive thinking and be sure you’ll do well enough with your trading to repay the loan. We don’t need to look too far to see what that sort of mindset did to people in the housing market.
Borrowing to Invest in Your Retirement
Now, having said that, there can be instances where borrowing (or not paying down debt, which is effectively the same thing) to fund investing or tradingÂ makes sense. That’s when you can lock in a spread. The easiest example of this would be borrowing at 5% and being able to put that into a 7% bond, or something of that sort. There are other situations where things are a bit more complex.
Consider an IRA (or another equivalent tax-deferred retirement investment account). Depending on your marginal tax rate and the rate you’d pay on the debt in question, it could make a lot of sense to borrow to fund a contribution to that account. Let me walk through an example to demonstrate.
The maximum current annual tax deferred contribution to an IRA account for an individual is $5000. Let’s say that we can borrow at 10% and that our marginal tax rate is 28%. The length of the loan impacts how much of a benefit we see in doing so. With that in mind I’ll present two different scenarios. The first is a 1-year loan. The second is a 5-year loan.
Tax Benefit: $1400 (28% marginal tax rate x $5000)
Loan Interest: $275 ($439.58Â monthly paymentÂ x 12 – $5000 initial amount)
Net Benefit: $1125
Tax Benefit on the IRA investment: $1400 (28% marginal tax rate x $5000)
Loan Interest :Â $1374 ($106.24Â monthly paymentÂ x 12 – $5000 initial amount)
Net Benefit: $26
That’s just a first cut look at things. If that $1400 tax benefit is actually a tax refund, it could be used to paydown 28% of the loan, reducing the total interest cost of the loan, especially for the longer-term one.
I’m not even including the actual return on the IRA investment in the equations here. At a 5% rate of return (compounded), that $5000 grows to over $8000 in 10 years and over $13,000 in 20 years.
This does, of course, assume that you can make the requisite payments from your normal pay since you certainly won’t be pulling money out of your IRA to do so – unless you want to get hit withÂ a penalty and tax bill. Run the numbers, though. See if it makes sense in your circumstance.