Monday, December 12, 2011

Don't borrow to invest

Initial public offers, gold, infrastructure bonds… investors never had it better. Consider for example: Coal India’s public issue, which saw a phenomenal response from investors, is expected to list at least 20-25% premium over the issue price when it gets listed on the stock exchanges today.

The IPO market is buzzing with frenetic action with several real estate developers and infrastructure companies including Lodha Developers, Neptune and Reliance Infratel slated to hit the market soon. As for gold which has been defying gravity for sometime now, less said the better.

If deep pockets are spoilt for choice, empty coffers have no cause for complaint either. For example, those who are eyeing the IPO space with no money to spare have received loan offers from banks and non-banking finance companies (NBFCs). Public sector banks are offering women loans to buy gold. Private sector banks and credit card companies are also luring buyers with offers to convert their gold coin or jewellery purchases into equated monthly installments (EMIs) that can be paid off via credit cards. Several banks are offering 3-9-month EMI schemes for buying gold coins this festive season.

But hold on a second. Common sense says you should invest with your surplus money, right? Borrowing to invest? Is it such a smart move? For example, what happens if the IPO that you have invested in lists at a huge discount to the issue price. It’s a double whammy. You have to bear the interest cost plus the losses. The same holds true for gold which does not look to be in a hurry to come off the highs that it’s currently riding on.

“A high net worth individual can earn some money by borrowing if he already has money parked in, say, a liquid fund. He can pull it out for down payment and borrow the rest of the money for 10-12 days, which will come at around 15-20% interest. The chances of allotment increase in case you take IPO financing as you are bidding for a higher allotment,” says Manish Bandi, vice-president, India Infoline .

In short, you will have to shell out half the money required for investing in an IPO from your own bank account and the balance amount will be funded by the bank or non-banking finance company. The interest charged is 21% in some cases.

And, mind you, it is not 21% per annum, but 21% for the 10-12 day period. This means that if you have taken a loan to invest in an IPO, priced at Rs 100 a share, you will have to make at least Rs 125 to just recover the cost of funding, including the processing charge. “There is always a chance that the listing gains may not give you good returns. In that case you will have to hold,” says Mr Bandi.

That really is the problem. What if everything doesn’t work according to plan? If the IPO fails to list at a premium, you will land in a soup. First, you have to repay the loan you have taken from the bank or NBFC within 10 to 30 days of taking it. So, what will you do? Sell the stock and return the money and bear the loss with a grin?

Even with a happy ending (read listing), the leveraging can cap your profits. Obviously, if you borrow at a higher rate to invest, then even at a phenomenal return, your profits will be affected. “The cost of funds should not be too high because even if the IPO gets subscribed heavily and the listing gains are higher, your cost per share will also be very high,” says Mr Bandi.

This is what happened in the case of a stock trader. “We had this gentleman who has been investing in shares. He borrowed Rs 30 lakh to invest in the share market. Soon after, the market collapsed. He was not employed anywhere and was surviving solely on this trading income from the share market,” recounts VN Kulkarni, chief counsellor at Abhay Credit Counselling Centre. “We told him that if you had a regular income, we could have still requested the bank to alter the EMI, but you don’t have any regular stream of income. The bitter lesson: Do some calculations about how you are going to pay back the loan. You shouldn’t enter waters that you don’t know about.”

The interest will also increase the losses incurred. “Investors should be aware that the loan taken for making investments will have to be serviced, in terms of interest and repayment, irrespective of the outcome of the investment,” says an Axis Bank spokesperson. “The amount of loss will increase by the amount of interest that is payable on the loan.

Also, if the loan tenure and investment tenure do not match, the investment may have to be liquidated at an inopportune time to repay the loan and this may result in a loss on the investment,” he adds. Add to that a penalty in terms of added interest rate. Some banks charge a penal interest of 2% per annum over and above the rate of interest on the loan outstanding in case of late payment.

Same is the case with the loans offered on credit cards to purchase gold coins or jewellery that is offered at “0% interest”. To begin with, the jeweller will offer the same jewellery at a different price, depending on the mode of payment as there is a transaction charge and processing fee attached to these schemes. In case there is no processing fee, check the tenure of the loan. For example, there are schemes where the processing fee and interest is 0% only if loan on credit card is repaid within three months as EMI. If you opt for an EMI of six months, then the interest rate is 0.99%, while the processing fee is Rs 70 for every Rs 1,000 of the loan amount. This processing fee also adds to your cost of purchase.

“People should see the processing fee. The cost of goods under the scheme and without the scheme should remain the same,” says a former credit card head with a multinational bank. “After the interest- free period, check whether the card company charges the interest from the first day. For example, if you don’t pay the third EMI, the bank will charge the interest for three months – starting from the day you took the loan. Most schemes charge the credit card interest rate on the entire (original) amount outstanding, which may be as high as 42% per annum,” he says.

Before taking up the credit card offer, “you should see the rate of interest, the capacity to pay back as, in case of default, it will reflect in your credit history,” says Kulkarni. But he adds that if you are building an asset and using finance for it, then the idea is good. “Borrowing to purchase a gold coin is fine as there is an asset that you are getting by paying the loan in instalments. You are investing in something where the price will not immediately crash and you may not be having that kind of money to purchase gold.”

Source: Economic Times

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