Should You Borrow Student Loan Money To Invest?

Back when I was soliciting questions from you before Thanksgiving, one of the questions I received from a reader concerned the wisdom of taking out student loans to invest. That’s a question that I have gotten two or three times before and never had the time to answer, so I’ll tackle it now.

The short answer is no. The longer answer is: I don’t know who you are borrowing the money from, but most likely, you are signing a contract that has restricted potential uses for the money that you borrow. Most likely, “investing the money” violates the contract. Look, nowadays, everything you do leaves behind a digital trail. If you take out $15,000 and in short order purchase 500 shares of General Electric, it wouldn’t take much of an investigation to figure out what where the loan money went. Things will be much easier for you if you don’t even introduce that kind of risk into your life. Plus, when you adjust for the 3.4% or 6.8% interest (or whatever your rate may be) plus the fees and potential taxes on any capital gains you may make with the money, the potential for making substantial money is pretty low. And this doesn’t even touch on what happens if you make poor investments with the loan money. It’s just not worth it. This isn’t even necessarily about morality–the risks of you not investing the money well plus the risks of getting caught outweigh any potential benefit you’d likely get from this action, making it against your interest to do so.

So that’s my answer. But since I have a 1,000 word target for most of my posts, I’ll rephrase the question: If you have access to borrowing rates that are well below the historical performance of the S&P 500 by a decent-sized spread, is it an intelligent strategical decision to borrow money to do so?

In some ways, the timing of questions like these indicate part of the problem: the investor with the right long-term orientation would be asking this question in 2008, 2009, or 2010, when the valuations of most stocks were much lower, and therefore, the hurdle for satisfactory returns was easier to meet. Now that we’re looking at gains after gains after gains, the willingness to take on risk starts to show up in questions like these. But still, that doesn’t answer the question.

The right answer for you depends on your attitude towards debt. If you think purely in terms of rationality, and don’t experience strong emotional or behavioral reactions regarding debt, then it might make sense to borrow money if the gap is substantial. If you can borrow money at 4-5% for ten years, you could probably put it all in a S&P 500 Index Fund and turn a profit on the spread, barring a low-valued stock market year like 1973, 1974, 2008, 2009, etc.

For someone with my temperament, the answer would be an easy “no.” One of the things I enjoy about stock-market investing is the autonomy it represents for me. I dislike employee-employer relationships where the second I show up late or rub someone the wrong way, my ability to earn an income disappears. I’m not comfortable with the power dynamics that are inherent in an arrangement like that.

For me, the “purity” of stock ownership is that, well, I’m the part owner. If I purchase 100 shares of Coca-Cola, I’m the boss. I can’t got fired. Granted, I can’t order anyone around or make strategic decisions on the company’s behalf, but the arrangement of the tradeoff is that I’m going to be getting north of $100 each year without putting forth any labor beyond buying the stock. It’s an entirely “no pressure” arrangement. Money shows up, and as the profits grow, more money shows up.

Even in the worst case scenario, no affirmative duty can be imposed on me by my stock ownership. The worst that could happen is that I don’t get any more dividends or I can’t sell those 100 shares for anything.

But once you take on debt, you’re changing that arrangement. If you borrow $25,000 to borrow 500+ shares of Coca-Cola stock, then you are “putting pressure” on that holding. If the profits, dividends, and stock price doesn’t increase in excess of your borrowing costs, then you are losing money. And, if God forbid, the stock you select goes bankrupt, you’re on the hook to pay $25,000 and you don’t even have a shiny car to show for it.

For me, it’s about the duties that are taken on, and the effects that has upon the quality of life. When you work for someone, you are at the mercy of an employer. When you borrow money to invest, you are at the mercy of the stocks to perform in a satisfactory way so that you can pay off the banks. What fun is that?

By the way, I don’t pretend to suggest that my way is universally applicable to everyone. In his mid-30s, Charlie Munger started to get very, very rich, very, very fast by employing leverage. Being young and having a lot of money can create very interesting opportunities for you. If you are damn good at picking energy MLP, and can borrow at a low enough rate, you could effectively print your own money by using the MLP distributions to pay off the debt. That skill set could allow you to treat debt like your own printing press.

However, if you’re smart and intelligent at allocating capital, you’ll get rich anyway. By creating a big ‘ole gap between what you make and what you spend, and wisely allocating the difference, you can advance your lifestyle in a significant way without thinking “General Electric must get to $45 per share by 2016 or else I lose.” You can’t go bankrupt if you don’t owe anybody anything, and the emotional satisfaction of seeing money come in free and clear without any strings attached ought to give you emotional satisfaction that you can’t achieve when the bankster is at your back. But then again, you’re the one who has to live with the opportunity costs of all of your decisions. When you hear the phrase “you only live once”, some people see that as the siren call to take risks. Others see it as a responsibility to live in a way now that won’t punish the future version of yourself ten years from now.

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8 thoughts on “Should You Borrow Student Loan Money To Invest?

  1. ronrph says:

    This is rather timely. I am long out of school but I did get a new credit card that is giving me 0% interest on purchases for 12 months. I have also recently learned about Loyal3 which let's you purchase stock (albeit in $50 increments) via credit card and with no transaction/broker fees. So in essence I can buy stock in a select group of companies with no fees and no interest for a year. I find this only valuable if there are companies I want to invest in. And assuming Loyal3 is on the up and up. I've never heard of them before……
    I've set up 5 companies: dr pepper/Hershey's/walmart/target/VF corp that I will invest $1k each and go from there. I figure it will take just over a month to get the $5k invested at $50 a pop. That will give me 11 months to pay off the $5k.
    They offer a few other companies I am invested in too.

  2. gregturn says:

    Interesting perspective. I have actually applied the spare cash from me HELOC to buy a major position in VNR. The distributions are almost 9% while my HELOC is interest only at 4%. I get monthly distributions, and have been silently knocking out the HELOC debt. But I only entered this after weighing all the risks and knowing that I had an exit strategy.

  3. ddh81 says:

    Borrowing money is just always making a deal with the devil (eventually). Buffett had a very quick summary in his 2010 shareholder letter:

    Unquestionably, some people have become very rich through the use of borrowed money. However,
    that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re
    clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very
    few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in
    2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a
    single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart
    people.
    Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that
    these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either
    because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by
    payment. For that, only cash will do the job.
    Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed.
    When either is missing, that’s all  that is noticed. Even a short absence of credit can bring a company to its knees.
    In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close
    to bringing our entire country to its knees.

  4. gregturn says:

    I use prudent leverage on my real estate as well as owning some VNR stock. That means I put 20-25% down when buying rentals (not 0% down like some people I know). 
    Debt is definitely risky. And that's why I mitigate it by holding around $35,000 in a savings account, to cover me in case something goes wrong. Debt can be sneaky and lure you in, but its also shown that home mortgages have built huge amounts of wealth over time for people. Its actually a strong wealth building tactic to wake up and figure out how to get more mortgages with decent risk mitigation plans in place.

  5. OldPartridge says:

    Hi Tim, I totally agree with your comments about borrowing to invest. It is not for everybody. I have seen people get rich with leverage in a rising market, only lose it all when the tide goes out. Here is my approach, which seems to work for me. I love to buy high quality stocks that pay dividends. The kind of stocks you write about. Since I have more ideas than cash, I use light margin (no more than 10%) to make my purchases. I expect the dividends will payoff the margin debt in about 3 years. I have not pencilled it out as to whether I am making money, losing money or breaking even. And I do not expect to get rich doing this. That will come from living way below my means and investing the surplus cash I earn just as you suggest. However, I found this approach helps me to focus, diversify into other names and I get a tax deduction at the end of the year!

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