Would you borrow money from the bank to invest in the stock market?
The reaction that I expect is “Are you out of your mind?” How about if I ask “Would you borrow money from the bank to buy a house?” I expect the opposite reaction “That’s probably smart if you can afford the monthly payments.” As crazy as this may sound, both scenarios are very similar. Most people know that historically real estate has been a great investment either through personal experience, friends, relatives, or just reading the news. The biggest reason that real estate helps people grow a lot of wealth is because they are able to borrow money from the bank at a relatively low interest rate (~3–4%/year) and get much better performance in the long run (~8%/year).
Let’s go over the 2 scenario in more depth:
- Buy a 1M house in the bay area: Let’s assume that someone puts 200K down and borrows 800k from the bank at 3.5%/year. In an average economy, you’d conservatively get 3% appreciation on the house. The nice thing is the “dividend payment” which is the house you get to live in. A comparable house to rent would be ~50k/ year (~$4200/mo in rent). This is equal to a 5% “dividend payment” because of the opportunity cost of living in a house to rent. The overall increase of wealth is ~8% (3% appreciation and 5% “dividend”), while paying 3.5% interest, so 4.5%/year overall gain on the 1M, while only using 200K of your own money.
- Invest 1M in S&P500: Let’s assume you have 200K in cash, and you’re able to convince a bank to let you borrow 800K at 3.5%/year (home owners can use their existing homes as collateral to convince a bank). In the average economy, you’d conservatively get ~4% appreciation for the fund. However, you’d additionally get ~4% dividends as well, which gives you an 8% return on 1M, while paying 3.5% interest. This would also net you 4.5%/year overall gain on the 1M, while only using 200K of your own money.
Now borrowing money from the bank to invest in the stock market doesn’t sound as crazy, does it? I believe that the difference is purely emotional, mostly due to the lack of easy liquidity of real estate. People don’t check their house value every day, but they check the stock market every day. Having completely accurate knowledge of the asset’s value in the stock market and the ability to sell so instantly allows people to panic more due to the cyclical nature of the stock market. This is ill-advised unless someone is purposely planning for short term investments (higher risk/ higher reward).
Few other real estate investing articles I wrote:
Hello everyone, I previously wrote about renting versus owning property. Now, I want to talk about different options…medium.com