Borrowing is risky, but we believe that proactive, prudent, and strategic borrowing can enhance an investor¡¯s financial plan, especially as interest rates fall over the course of 2025.
We expect further major central bank rate cuts over the course of this year, building on the European Central Bank and Swiss National Bank decisions earlier in 2025. We expect US GDP growth to slow to around 1.5% in 2025, down from 2.8% in 2024, and our base case calls for 100 basis points of Fed rate cuts starting in September. Falling interest rates make it harder to generate income, but potentially increase the opportunity to use borrowing strategies.
We would note that market declines in the wake of "Liberation Day" tariff announcements (and the speed of equity markets' rebounds) may have clouded the borrowing outlook for some investors. This underscores the need to manage risks and take a flexible approach to any lending strategy.
Yet, if risks are managed assiduously, borrowing can help with:
- Managing liquidity: A flexible line of credit can provide immediate access to funds without the need to sell assets, reducing the necessity of holding excess cash, money-market funds, or fixed-term deposits. This may be beneficial for handling tax bills, capital calls, or retaining the flexibility to make larger investments.
- Improving diversification: Borrowing against existing assets to invest in less correlated assets may help smooth portfolio fluctuations and broaden return sources, with future cash flows used to gradually reduce debt.
- Currency management: Borrowing in foreign currencies can help manage exchange rate risks associated with future foreign income and offer additional funds for domestic investments. It may also be more cost-effective to borrow in a foreign currency with a lower funding cost, subject to careful risk management including tools to limit adverse impacts from an appreciation in the funding currency.
- Boosting return potential: For those with a high risk-tolerance, borrowing could potentially lead to higher long-term gains if returns exceed borrowing costs, particularly as interest rates decline. However, this strategy is risky, as leverage can amplify both losses and gains.
Before engaging in borrowing, investors should carefully consider both the cost and robustness of any loan.
Costs involve comparing loan rates with expected returns for the investments in which borrowed funds are put to work.
If the expected return of the intended asset is lower than the borrowing cost, then borrowing clearly does not make financial sense. If the expected return is higher than the borrowing cost, then taking on debt could make sense.
It is important to remember that short-term returns often deviate significantly from long-term expected returns, and this borrowing cost-to-¡±expected-carry¡± analysis will almost always appear favorable. As a result, cost should not be the only criterion for deciding when to use liabilities.
Robustness checks include considering refinancing and interest rate risks, being aware of the potential for margin calls during market fluctuations, and understanding the impact of spending plans on the ability to service or repay a loan. If a family or investor expects to tap a portfolio for large expenditures, such as university tuition for children or a home purchase, an important consideration would be how long the portfolio could take to recover (the ¡°time underwater¡±) and the impact that spending might have on a projected loan-to-value ratio.
If, after making such planned expenses, the investor's assets will still hold enough value to avoid a margin call in a worst-case scenario, a borrowing plan can be considered robust. If, however, the plan leaves little margin for error¡ªor if there is a projected shortfall¡ªit may be necessary to reduce leverage.
Whatever the objective of a borrowing strategy, it's vital to develop a specific plan for paying off the loan:
Identify a specific source of funds. This could be the sale of an asset, or projected cash inflows from a business or salary.
Formalize a specific timeline. While it's fine to reassess financial plans as things change, setting out a formal schedule for repayment can stop borrowers from procrastinating and help them stay focused on managing the risk and cost of their debt.
Develop a ¡°Plan B.¡± It can be advantageous to identify an alternative source of funds to repay debt in case the asset sale or cash inflow initially expected doesn't occur or is delayed. Setting specific criteria for triggering this backup strategy may also be prudent, especially if the liability is growing over time.
Stress test plans. Borrowers would do well to consider how they might deal with unexpected expenses, or with market stresses that impair the asset side of their balance sheet. It is crucial to account for the risk of a margin call and act proactively to keep a buffer against that scenario.
For any investor planning to use leverage as a part of their strategy, we recommend following these three guiding principles:
Use debt to diversify and build resilience.
Avoid a mismatch between the duration of liabilities and the duration of assets.
Manage liabilities proactively.
Investors should be able and willing to bear the unique risks of borrowing and build a flexible financial plan that can adapt to multiple economic scenarios without compromising their long-term financial goals.
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