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Should I Borrow to Lend?
I remember working at stock-market investment website The Motley Fool when Stuart Watson was the editor. He was a smart guy.
That's why, when I told him a friend was re-mortgaging his house to invest in the stock market, he had a very intelligent response, albeit not with his usual coherence. It reminded me on the spot of this scene and it went something very much like this:
“Bluahh! Bah! Wha-haaa? Errrr! You can't be serious?”
I couldn't have put it better myself, which is probably why he was editor and I was just a lowly journalist.
It was a sad story, because this friend took that decision shortly before the stock market and property crash of 2008. But it doesn't take something as dramatic as that to turn borrowed investments into a disaster.
Higher costs, lower returns, higher risks and more risks
Just a few bullet points to get you thinking:
- If you borrow to lend, your costs of lending are higher, because in addition to paying the costs of the investment (in this case, the money that the P2P lending sites in the middle keep), but you also pay interest.
- If costs are higher, the reward you get is lower. Simple example, if you normally receive 10% interest but you're paying out 5% interest on the money you've borrowed, you're just earning 5% now.
- The risks of losses from bad debts are higher: you can more easily lose all your money. If you have £1,000 of your own money lent and borrow £9,000 to lend on top, what if you lend unwisely or have bad luck, losing 10%? That means that you have lost £1,000 – which was all the money you had! You still have to pay back that £9,000. If you had just lent your £1,000, you would have £900 remaining after losing 10%.
- There are many additional risks in borrowing to lend that completely change the equation, the risk-reward balance. You have to be confident that you'll be able to meet the debt repayments punctually. You might even need to borrow again, because you're unable to sell your P2P loans on time, for a variety of reasons.
Your rewards can be magnified if you borrow to lend, but your risks multiply too!
Here's an example
Borrowing to lend through P2P isn't fantastically safer than borrowing to put money on the stock market.
Let's say you earn around 5.5% after fees and bad debts, but before taxes, through P2P lending. Great.
But a higher-rate taxpayer will pay at least 2.2 percentage points in taxes.
Then you also have borrowing costs. If you re-mortgage these days you might pay as little as 2.5%. Maybe fees are on top too, but let's leave that out for simplicity.
That leaves you with a mega profit of 0.8%.
Would you lend for 0.8% interest?
The first question is, would you lend for 0.8% interest with your own money? I mean, if you weren't borrowing it? That was a rhetorical question; I know the answer already.
…OK, I just want to make sure you've got the same answer as mine. It was a “No”.
Borrowing money comes with risks
So if you wouldn't lend for 0.8% with your own money, borrowing to get that return clearly doesn't make sense.
Borrowing to lend hugely increases your risks. If you don't make enough money to cover your taxes and mortgage repayments, you lose. If something really hits the fan, you could lose the house – literally!
What if you lose your job? If mortgage rates go higher and you can't repay due to lending losses?
I'm just touching the surface of what can go wrong here.
All for 0.8 measly percent.
Imagine a better situation
Let's imagine a more favourable situation for borrowing to lend in the future: IFISAs – P2P ISAs – are already here, which means tax-free lending. Mortgage rates are still low and you can now fix your 2.5% for five years.
If you're earning 5.5% after fees and bad debts, you're now making 3% after everything including paying your mortgage
That's a lot better than 0.8%. Is it enough? I hardly think so. Here's one simple way to think about it.
Currently, cash ISAs pay as much as 2.3% fixed for five years. (See a comparison of Safest Peer-to-Peer vs Savings Accounts.) It's pathetic. But it's pathetic because the rewards match the risk you're taking – which are about as low as they get.
If you borrow to invest, with all the risks of both of them combined – which is greater than the sum of their parts – you can hardly imagine it's a fair reward to earn just 0.7 percentage points above a cash ISA.
There are probably extreme situations where a small number of people might be able to justify borrowing to lend for short periods, based on a combination of their circumstances, borrowing rates and lending opportunities that are low-enough risk, and a cunning eye for special situations.
But, realistically, most of us should chuck that idea and focus on sensible, safe strategies.