While a person could theoretically use a personal loan to invest, it is generally not a great idea. That’s because there are a number of risks associated with using a personal loan for investment. For one, there’s always the risk that you could lose the money you invest, which could make it challenging to repay the loan. And then there’s the fact that taking on debt to invest involves paying interest. Depending on the rate you qualify for, you could end up paying more in interest than you make in returns from investing.
If you’re considering using personal loans to invest, it’s important to understand the potential downsides. Weigh those against any possible gains to see if it actually makes sense for you.
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Can You Use Personal Loans to Invest?
Personal loans allow you to borrow a lump sum of money that you can use for virtually any purpose. Some of the most common uses for personal loans include home improvements, debt consolidation, vehicle purchases, medical bills, and emergency expenses. You can also generally use a personal loan for investing, unless the lender specifies otherwise. While personal loans typically allow for flexibility in how the money can be used, lenders have the option to impose restrictions.
So why would someone use personal loans to invest anyway? There are different reasons for doing so. For some, personal loans for investing could make sense if:
• They don’t have other cash available to invest.
• Shifts in the market have created a buying opportunity they’d like to capitalize on.
• Personal loan interest rates are low compared to the return potential for investments.
• They can afford to make the payments on a personal loan.
When Using a Personal Loan to Invest Might Make Sense
Ultimately, whether you should consider using personal loans for investing may hinge on your investment goals, timeline for investing, and risk tolerance. There are some situations where it could make sense.
1. You Can Qualify for the Lowest Rates, Based on Credit
One of the most important factors that lenders consider when approving personal loan applications is credit. Specifically, your credit scores and credit reports will come under scrutiny. The higher your credit score, the lower your interest rate on a loan is likely to be. If you’re interested in using personal loans for investments then getting the best rate matters.
Why? While you might be earning returns on your investments, you’re paying some of them back to the lender in the form of loan interest. So it makes sense to angle for the lowest rates possible, which are generally offered to those with good to excellent credit.
2. You May Be Able to Pay the Loan Off Early
Being able to pay the loan off ahead of schedule could help you save money on interest charges. Given those potential savings, think about your budget and what you might realistically be able to afford to pay each month to get the loan paid off early.
But be aware that doing so could trigger a prepayment penalty. While SoFi personal loans don’t have any prepayment penalties, for instance, other lenders may charge them. If you get stuck paying a prepayment penalty that could wipe out any interest savings associated with paying the loan off early.
3. You’re Confident About Your Return Potential
Some financial experts might say that personal loans for investing only make sense when the investments are guaranteed to get a return that outpaces what’s paid in interest on the loan. But trying to predict a stock or exchange-traded fund’s future performance is an inexact science and not a recommended practice.
For that reason, it’s important to consider how confident you are about an investment paying off. This is where you may need to do some research to understand what an investment’s risk/reward profile looks like, how well it’s performed in the past, what’s happening with the market currently, and where it might be headed next.
In other words, you’ll want to perform some due diligence before using loans for investments. Looking at both the upsides and the potential investing risks can help with deciding if you should move forward with your personal loan plans.
When You Might Think Twice About Using Personal Loans for Investing
While there may be some upsides to using personal loans for investments, there are some potential drawbacks to weigh as well. Don’t let your dreams of investing success cloud the realities of the risks involved.
1. You Don’t Qualify for the Best Rates
When using personal loans for investing, the math becomes important, since any interest you pay has to be justified by the returns you earn. Even if you’re investing in something that you’re sure is going to result in a sizable gain, you still have to consider how interest will cut into those gains.
If you don’t have great credit then any returns you realize may be overshadowed by the interest you’re paying to the lender. Before applying for a personal loan, it’s helpful to check your credit reports and scores to see where you stand. This can help you gauge what type of interest rates you’re most likely to qualify for if you do decide to go ahead with a loan.
Also know that the total interest cost increases the longer you pay on the loan. If you’re considering a two-year, three-year, or even five-year repayment term, make sure to keep that in mind.
2. You Have a Lower Risk Tolerance
Investments aren’t risk-free, and some are riskier than others. If you’re taking on debt to invest in the market, you have to be reasonably sure that your investment will pay off. In the meantime, you need to be comfortable with the risk that involves.
The stock market moves in cycles, and volatility can affect stock prices from day to day. So it’s good to understand how you typically react to volatility and what level of risk is acceptable to you before taking out a personal loan. If the idea of being stuck with a loan for an investment that doesn’t pan out isn’t something you can stomach, it may not be right for you.
Likewise, you may want to take a pass on a personal loan if you’d be investing in something that you don’t fully understand or haven’t thoroughly researched.
3. Your Income or Expenses Could Change
Taking out a personal loan means you’re committing to repaying that money. While you might be able to afford the payments now, that may not be true if your income or expenses change down the line.
Something investors might not like to think about, but that is a risk, is the possibility that the market doesn’t perform favorably. What happens if there’s a loss on the investment and you have to find other funds to make the personal loan payments? The reality is, even if the investment doesn’t provide the return that’s expected, the lender will still expect payments on that personal loan.
Before applying for a personal loan, ask yourself whether you’d still be able to keep up with the payments if your income were to decrease, your other expenses were to go up, or the investment didn’t see the return you thought it would. If you don’t have an emergency fund in place, for instance, how would you manage the loan payments? Would you have to sell the investment to make a loan payment? Could you borrow money from friends or family?
Thinking about these kinds of contingencies can help you decide if a personal loan for investing is the best way to go.
What to Consider With Personal Loans for Investing
Before taking out a personal loan for investing, there are a few things to keep in mind. For instance, consider factors like:
• How much you can afford to pay each month toward a personal loan
• How much you need or want to borrow
• What the current personal loan interest rates are
• Which rates you’re most likely to qualify for based on your credit history
• Any fees a lender may charge, such as origination fees or application fees
• Whether you’ll be able to repay the loan early and if so, what prepayment penalty might be involved
Beyond credit scores, also consider what else is needed to get approved for a personal loan. For instance, lenders may look at your debt-to-income ratio, employment history, and intended use for the loan proceeds.
Also think about how you want to invest the money. If you’re interested in trading stocks or ETFs, for example, you may want to choose an online brokerage that charges $0 commission fees for those trades. The fewer fees you pay to your brokerage, the more of your investment returns you get to keep.
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The Takeaway
Using personal loans for investments carries some definite risks. It’s a strategy to steer clear of if you don’t qualify for the best rate on your loan, you have a lower risk tolerance, or your income or expenses could change down the road. Only in select circumstances could it make sense — though remember there’s no guarantee of any investment returns.
As such, personal loans are likely better left for other purposes, such as covering emergency expenses or making necessary home repairs. If you are considering getting a personal loan, make sure to shop around to find the right offer. Personal loans from SoFi, for instance, offer competitive interest rates.
Photo credit: iStock/jacoblund
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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