If you're like me, you may be wondering if you should borrow money to invest in the ASX. The S&P/ASX 200 Index (INDEXASX: XJO) climbed 20.27% higher in a record-breaking 2019. If you had $20,000 invested in an index fund, that means you made $4,000 last year.
If you're investing for the purposes of putting down a house deposit or even for retirement, $4,000 really doesn't seem like much – particularly when you consider that 2019 was a bumper year for the ASX 200 and not every year would return the same level.
One way that you can supercharge your returns is to borrow money and invest in the ASX. But is it a good strategy for your portfolio?
Why you can borrow money to boost your ASX returns
There is no doubt using leverage can have huge benefits for your investment returns. It's very common to use leverage in real estate, meaning you use someone else's money to get a higher return on investment (ROI).
A simple example is all that is needed to demonstrate the benefits of borrowing money and investing.
If I save $100,000 and invest in a high-yield ASX dividend share like BHP Group Ltd (ASX: BHP), I could be getting 4.67% or $4,670 per year in income.
That means for every dollar of your money that you have invested, you will get back $0.467 in earnings.
However, say I save $10,000 and borrow money for the rest (i.e. $90,000) to invest in those same BHP shares.
I would now receive the same $4,670 per year, but with just $10,000 of my own money. That means my effective return has now been increased to $4,670/$10,000 or 46.7% thanks to the use of leverage.
But wait… there are risks.
While the use of leverage may sound great, basic finance tells us that with higher returns come higher risk.
While you can borrow money to invest in the ASX like in the above example, your risk can increase massively.
Often this type of strategy involves margin lending, where you borrow against the value of your shares to secure your loan. But if your ASX shares can go up, they can also go down.
In the above example, if the BHP share price dropped 5%, you would lose $5,000 of your original $100,000 investment on paper.
However, if you've borrowed the $90,000 dollars, that loan is still required to be paid regardless of your investment. On top of that, you may be subject to a margin call where the lender requires more collateral as security for your loan.
Foolish takeaway
It is entirely possible to borrow money to invest in the ASX, but it is incredibly risky. It's certainly not a strategy that the average investor should be using.
If the market turns against you, you could be facing an un-payable loan and even bankruptcy. So as always, seek out the advice of a professional before leveraging your ASX portfolio for extra returns.
If you're interested in a lower risk entry to using leverage, there are exchange-traded funds (ETFs) available. One such example is BetaShares Geared Australian Equity Fund (ASX: GEAR), which does the leveraging for you at a fund level.
