For some of you, borrowing is unthinkable. For others, it is a way of life. While using one’s own capital to create personal assets can give peace of mind, it also limits your ability to accumulate wealth. On the other hand, borrowing excessively to build wealth could be risky. In this article, we show you whether it is rationel to resort to borrowing to create consumption or investment assets.

Consumption asset If you buy a house to earn rental income, you have created an investment asset. But if you buy a house for self-occupation, you have created a consumption asset. Your consumption asset is not part of your investment portfolio, but forms part of your total wealth.

The question is: Whether it is behaviourally optimal to borrow and create consumption asset, but not investment asset? The answer lies in the intention behind creating both the assets.

You create a consumption asset for enjoying its benefits over a period of time. Self-occupied house and the precious jewels (that you keep in your bank locker) are the two of the major consumption assets. Can you own a self-occupied house without borrowing money? For many of us, the answer is no.

While one usually does not buy precious jewels with borrowed money, opting for installment schemes is also a form of borrowing.

In both these cases, your intention is to consume the asset and not resell it at a higher price. You are, therefore, not compelled to recover the additional burden of interest cost.

The same cannot be said of your investment asset; for your primary objective of creating an investment asset is to resell it at a higher price and generate capital appreciation. This means you face the pressure of having to earn a higher return than the total investment cost (including interest payment).

To cover these costs, you have to invest in high-risk high-returns assets such as equity and commodities. Why? Because borrowing money to create stable-income investment assets such as bonds is not worthwhile, as the borrowing cost is typically higher than interest income that could be earned!

However, investing in equities or commodities could also be risky. Not only can you lose a part of your investment capital due to decline in asset prices, but you will also be burdened by the fixed interest cost on your borrowings. Moreover, the anxiety of covering your borrowing costs on your investment asset can be too much to bear, especially in a volatile market. So, should you borrow at all to create wealth?

Investment asset The matter of fact is that you need both consumption assets and investment assets to balance your lifestyle needs. The question to ask yourself is: Are you borrowing to create leveraged wealth? If yes, you can use leverage to create consumption assets.

A significant proportion of your savings can instead be allocated to buying unleveraged investment assets. This is beneficial in two ways. One, you pay the lender as you consume your assets. And, two, you can reduce anxiety caused by borrowing to create investment assets, and yet build wealth.

Finally, consider this. You are subject to the risk of borrowing, whether you leverage for buying your consumption or investment asset. For a decline or unfortunate loss in income can be stressful because you will still have to find ways to repay your borrowings. To sum up, go for leveraging to create a consumption asset, if need be, than to create an investment asset! And if you still prefer to leverage to buy investment assets, consider trading index futures and single-stock futures. But keep these trading positions inside your satellite portfolio. Your core portfolio must be, preferably, unleveraged — with an eye over the long haul.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

Related Topics