Risk of investing with borrowed money. During a crisis you will be asked to put in more money to cov

Some banks lend money to consumers to invest in their products. This can be risky. Let me explain with actual examples.

DUAL CURRENCY INVESTMENT - INDONESIAN LADY

An Indonesian lady, who is not English educated, was introduced to a bank in Singapore. She put in $500,000 in an investment and asked for a low risk investment that can earn a return of 5% per annum.

The relationship manager (RM) introduced a dual currency investment that pays a return of about 5% per annum if the specified currency stays above a specified level. If the currency falls below that level, the investor has to take over the currency. The RM explained to her that she can hold on to the currency and wait for it to appreciate to the entry level.

To enhance her profit, the RM advised her to take a loan from the bank for 4 times of her investment, i.e. $2 million, at a borrowing rate of 1.5%. As the investor can make a yield of 5%, she can make the difference of 3.5% after deducting her borrowing cost of 1.5%.

During the global financial crisis, the invested currency dropped by 20% within a few days. As the investor had $2.5 million invested in that currency, the investment dropped by $500,000 wiping out her entire investment. The bank closed her investment to avoid further losses.

DUAL CURRENCY INVESTMENT - RETIRED TEACHER

A retired couple invested $200,000 of their gratuity in a similar investment. The bank lent them $800,000 (i.e. 4 times of their investment) to boost their returns. When the invested currency dropped by 10%, the bank called them to top up $100,000. As they did not have the money to top up, the bank closed their account. They lost $100,000 or 50% of their invested sum of $200,000.

If they did not close the investment at that time, they would have lost their entire investment of $200,000 when the currency dropped another 10%.

LESSON

The key lesson to learn from these two examples is "NEVER INVEST WITH BORROWED MONEY". It is highly risky.

If both investors had invested their own money, and did not take a loan from the bank, they could wait for the invested currency to return to the level that they made the investment. In the specified cases, the currency did return to the entry level after three years. They could have waited to recover back their invested sum.

As they had invested with borrowed money and could not top up the loss, the bank had to close their investment at a bad time, leading to a big loss.

There are many other financial products, sold by the banks, that follow a similar pattern. The bank will lend to the investor 4 times of the invested sum at a low interest rate. The investor did not realize that they are earning a higher return in a risky product which can incur large loss during bad times.

DUAL CURRENCY INVESTMENT

It is best for consumers to avoid the dual currency investment. During good times, they can earn a return of 5% per annum. During bad times, they could suffer a loss of 10%, 20% or more.

It is better for the investor to invest in the currency directly, rather than through a Dual Currency Investment product.

Tan Kin Lian