Why offer at a lower interest rate on a loan then the expected ROI of investing in the stock market?

Question

A quick google search told me that the expected ROI of investing in the stock market is roughly just under 10% That's admittedly a bit higher then I had anticipated, but quick scanning of their numbers didn't show any clear flaw with it. There is of course a decent risk in stock investments, but for a large enough company with enough money that risk can be adjusted and accounted for.

In comparison a quick search for the rate of secured loans, using either a home or auto vehicle as collateral, showed interest rates much lower then that; around 6-7% for home equity and I even saw a few places advertising less then 3% for auto loans - though that number seems so absurdly low I suspect they must be hiding something in their fine print.

I understand that a loan with collateral are lower risk then the stock market, but is the risk really so much lower as to accept only 2/3 the expected ROI from the stock market? Is there some other reason why secured loans would be preferable to just investing in the stock market? Is Google's expected ROI claim for the stock market too high? Are banks expecting to make a profit from late fees or repossessing collateral to make up the difference?

Put in another way, if we pretend I had a home is there any reason I shouldn't go out and get a home mortgage just to invest the loan in the stock market, other than that minor detail that I might end up homeless? Joking aside with my current nest egg I could be pretty confident I could manage even a fairly significant crash in the stock market without risking defaulting on my loan, my excess income alone should easily be able to cover a monthly minimum payment even if I lost all my investments. So if I'm comfortable with higher risk for higher expected ROI is there a reason I shouldn't be mortgaging my (non-existent) home right this second?

Answer 1

With a secured loan, there is very little risk of the loan not being paid back, either through the scheduled payments, paying off the loan, or repossessing the collateral.

In the stock market, there is a very real risk of losing at least part of your invest, with a worst case scenario of losing everything depending on how risky you get.

Risk and reward is always a tradeoff, and yes, stock market investments are risky enough to require many times the return of secured loans.

is there any reason I shouldn't go out and get a home mortgage just to invest the loan in the stock market

You're financing a risky investment with a"risk-free" loan. You might lose 10-20% or more of your stock market investment (realistically, not just catastrophically) in a year, but you'd still need to make the loan payments. If you have to cash out your depressed investments just to make the loan payments, you're compounding the problem by having less capital, requiring an even larger gain just to break even.

Suppose you borrowed 1,000 at 6% (0.5% per month) for 5 years, for a payment of $30 per month. You then invest it expecting to make 1% per month. If the stock returns were fixed, you'd make 10 per month and pay 5 in interest, for a profit of 5 in the first month.

But suppose the market goes down 2% one month. You now lost 20 and had to pay 5 in interest for a net loss of 25.

In order to make back that 25, the market has to go up 2.5% in a month (not just reverse the 2% it lost the month before). If you had to dig into your investments to make the mortgage payment, meaning it now has a balance of 950 (the 20 loss plus the 30 payment), the market has to go up 2.63% to make back the 25 lost. So losses can multiply significantly when using leverage (borrowed funds).

Now, if you can afford to cash-flow the mortgage outside of your investment account, then you might be able to afford to take some short-term losses, but then you wouldn't need to borrow when investing.

Bottom line: borrowing to invest multiplies your risk, and can only be done "safely" (meaning you won't lose everything) when you have enough unborrowed capital to weather losses.

Answer 2

Since this is tagged "auto loan", and assuming it's a question about US car dealers:

They can do this because it encourages people to close the sale, much like shaving another hundred dollars off the price -- and the profit on the sale is much greater than the small amount they are giving up. Essentially it's an advertising cost, like any other discount.

Note that this means you should always nail down the price of the car before talking about the loan, since otherwise the dealer will want to make the price a bit higher so you, rather than they, are paying for the discount.