Is borrowing money good for you?

If you have $100 to invest in one of three different ways that gives back three different returns, say 12%, 15% and 20%, all on identical terms, which one would you choose? Obviously the investment that gives back 20%, right? Of course! Individually we want the most out of our money.

The counter intuitive concept in an investment is the fact that leverage helps to maximize the returns. In India, we are always told not to take loans ever. Even Kambar says, "Kadan-pattar nenjambol kalankinaan Ilankai vendan" when he refers to Raavanan. However, the fact is that borrowing funds to invest yields higher returns and is actually encouraged by Governments around the world including in India. Let's look at some math.

You invest $100 on a business that generates, say $120. i.e. 20% return on your investment. Clean and Simple.

Now suppose you borrow $50 from your bank at 10% interest and invest $50 of your money on the same business. You owe bank $5 in interest. So your returns is $15 on $50. i.e. 30% But wait it gets better.

All governments give incentives to people to borrow money because that increases economic activity of the country. That is, you get tax incentive on your interest payment. Suppose the tax incentive is 20% on the interest payment. You end up getting back $1 from Govt. for paying $5 interest to your bank.

That makes your returns to be $16 on an investment of $50. i.e. 32% return on your investment.

All you did was borrowed half the money from bank and played by the rules. You are subjected to the same risk in both cases of the business failing to generate the target revenue. But simply by leveraging your investments, you have increased your returns!

Before you rush to bank to borrow and invest, make sure your investment is guaranteed to generate the revenue. Don't borrow and invest in stocks!

Next, let's see how this math can lead to disaster if not handled carefully.