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To evaluate the potential pitfalls and merits of borrowing, we must first assess cost and robustness.
Cost is the first consideration. In particular, it is important to evaluate the difference between the estimated interest rate on any loan versus the expected return of the asset in which loan proceeds are invested.
If the expected return of the intended asset is lower than the borrowing cost, then borrowing clearly does not make financial sense. If the expected return is higher than the borrowing cost, then taking on debt could make sense. It is important to remember that short-term returns often deviate significantly from long-term expected returns, and this borrowing cost-to-”expected-carry” analysis will almost always appear favorable. As a result, cost should not be the only criterion for deciding when to use liabilities.
Robustness is a crucial second component. Borrowing that results in an investor being forced to sell assets to make a loan repayment is almost never a good idea. There are usually two main culprits that can lead to this scenario materializing: market risk and spending plans.
Market risk and margin calls. If the value of a loan's collateral falls, breaching agreed loan-to-value ratios, and a borrower lacks alternative funds, they may be forced to sell assets to meet a margin call or repay debt.
One method to assess this risk is to consider historical “maximum drawdowns.” Any estimate of potential haircuts should also account for illiquidity. Stocks, bonds, and many investment funds tend to be fairly liquid, while property, private business interests, and other illiquid assets could fetch far less if it became necessary to sell in a rush.
Loans against less liquid assets—such as property, private market fund holdings, yachts, or aircraft—aren't directly subject to the potentially damaging margin calls that can impact credit backed by stock portfolios or single stocks, but these loans may be callable on short notice. Investors should make sure not to borrow beyond their liquidity capacity; being forced into a “fire sale” of liquid assets can be damaging to long-term growth potential.
Spending plans are equally important. If a family or investor expects to tap a portfolio for large expenditures, such as university tuition for children or a home purchase, an important consideration would be how long the portfolio could take to recover (the “time underwater”) and the impact that spending might have on a projected loan-to-value ratio.
If, after making such planned expenses, the investor's assets will still hold enough value to avoid a margin call in a worst-case scenario, a borrowing plan can be considered robust. If, however, the plan leaves little margin for error—or there is a projected shortfall—it may be necessary to reduce leverage.
For much more, see , 17 February 2025.
