Capital Deployment: Understanding Loan And Investment Usage

Loans and investments are distinct financial tools with different purposes, risks, and implications. Loans are borrowed funds that must be repaid, whereas investments are funds allocated with the expectation of generating a return.

Loans are typically used to finance specific purchases or projects, such as buying a house, starting a business, or paying for education. The borrower assumes the responsibility of repaying the loan according to the agreed-upon terms and conditions. On the other hand, investments are made in various forms, including stocks, bonds, real estate, or even starting a business. Investments are not expected to be repaid but are intended to generate income or appreciation over time.

When deciding how to use a loan or investment, it is important to consider the level of risk involved, the expected returns, and the potential impact on your financial situation and credit.

Career growth

Investing in career growth can bridge the gap between employees and employers, benefiting both groups. It can help employees achieve their professional goals and progress in their careers, while also helping businesses attract talent, reduce talent acquisition costs, close skill gaps, increase employee engagement, retain employees, and improve business performance.

• Higher Education: A loan can provide financial assistance for paying tuition fees and other associated costs for post-graduation, professional certification, or vocational training. This can help individuals gain the knowledge and skills needed to advance in their careers.
• Training and Upskilling: Investing in additional training can enhance an individual's skill set and marketability. A loan can help cover the costs of tuition fees, course materials, and other related expenses.
• Attending Conferences and Networking Events: Networking is crucial for career advancement as it opens doors to new opportunities and connections. A loan can help cover the costs of registration fees, travel expenses, and accommodation costs associated with attending industry conferences and networking events.
• Starting a Side Business or Freelancing: A loan can provide the initial capital needed to launch a side business or freelance work, allowing individuals to supplement their income and turn their passion projects into lucrative career paths.
• Investing in Professional Development Tools: A loan can provide funds to invest in software subscriptions, online courses, and other resources that can enhance an individual's professional skills and keep them updated with the latest industry trends and technologies.
• Relocating for Better Opportunities: Advancing one's career may sometimes require relocating to a different city or country. A loan can help cover the upfront costs of rent, transportation, and security deposits associated with moving to a new location for better job prospects.
• Purchasing Professional Attire and Equipment: Investing in appropriate attire and equipment, such as business suits, laptops, or professional cameras, can enhance an individual's credibility and confidence in the workplace. A loan can help cover the costs of acquiring these essential tools for career success.
• Bridging Financial Gaps During Career Transitions: Career transitions can often involve periods of financial uncertainty. A loan can serve as a financial safety net during voluntary or involuntary career transitions, providing financial stability until an individual stabilises their income stream.

Improving credit score

Improving one's credit score is a common reason for taking out a loan. Here are some ways in which a loan or investment can be used to improve one's credit score:

Make On-Time Payments

Making timely payments is one of the most important factors in improving one's credit score. Payment history accounts for 35% of one's FICO score and includes on-time, late, and missed payments. Always making payments on time can significantly improve one's credit score. Setting up autopay for at least the minimum amount due and creating calendar reminders and alerts can help ensure timely payments.

Pay Down Revolving Account Balances

The amount owed accounts for 30% of one's FICO score, and credit utilization rate—the percentage of available credit used on revolving credit accounts such as credit cards—is a major element. Keeping credit card balances low and paying them off is crucial. Strategies such as debt consolidation loans, balance transfer credit cards, debt management plans, or debt repayment strategies can help manage and reduce debt.

Don't Close Your Oldest Account

The length of credit history makes up 15% of one's FICO score and is influenced by the age of the oldest account and the average age of all accounts. Closing old credit card accounts can hurt one's credit score, especially if it is one of the oldest ones. Keeping old accounts open, even if no longer used, or putting a small recurring bill on the card to keep it active, can help maintain a longer credit history.

Diversify the Types of Credit

Credit mix accounts for 10% of one's FICO score and involves managing different types of credit, such as credit cards, auto loans, and mortgages. Having a diverse range of credit types can improve one's credit score. Applying for a starter credit card or a credit-builder loan can help build credit history.

Limit New Credit Applications

Each time one applies for new credit, a hard inquiry is made on their credit report, which can knock a few points off their credit score. Limiting credit applications and checking if lenders offer prequalification, which uses a soft credit check that won't impact the credit score, can help maintain a good credit score.

Dispute Inaccurate Information

Inaccurate information on a credit report can negatively impact one's credit score. Disputing and correcting any errors or fraudulent information on one's credit report from the three major credit bureaus (Equifax, Experian, and TransUnion) can help improve one's credit score.

Investing in a business

Debt Financing

Debt financing is a common way for businesses to secure capital, typically from a financial institution such as a bank. It involves taking out a loan with agreed-upon repayment terms, including interest. The advantages of debt financing include the lender having no control over how the business is run and no ownership stake. Once the loan is repaid, the relationship with the lender ends. Additionally, the interest paid on debt financing is usually tax-deductible. However, there are also disadvantages to consider. Adding a debt payment to monthly expenses assumes a consistent cash flow to meet all business expenses, which may not be the case for small or early-stage companies. During economic downturns, it may be more challenging to qualify for debt financing.

Equity Financing

Equity financing involves raising capital from investors, who become partial owners of the business and may have a say in its operations. The main advantage of equity financing is that there is no obligation to repay the invested funds. Investors understand the long-term nature of building a business and are typically in it for the long haul. However, the downside is that business owners give up a portion of their ownership and may have to consult investors before making decisions. Equity financing can also be more expensive than debt financing due to the higher risk assumed by investors.

Mezzanine Financing

Mezzanine financing combines elements of both debt and equity financing. It is typically offered by lenders who have the option to convert unpaid debt into ownership in the company. This type of financing is suitable for new companies showing growth but lacking extensive financial data. It can make the company more attractive to future lenders and is often provided quickly. However, the interest rates tend to be higher due to the lender's perception of increased risk. There is also a genuine risk of losing a significant portion of the company.

Off-Balance Sheet Financing (OBSF)

OBSF is a strategy used by companies to keep large purchases or debts off their balance sheets, making them appear stronger and less debt-laden. It is not a loan but a way to structure transactions to improve the company's financial appearance. While this approach is highly regulated, it can be beneficial for one-time large purchases or debts.

Friends and Family Funding

For smaller funding needs, business owners may consider turning to their friends and family. This approach can offer more flexible and advantageous repayment terms. It can also be structured similarly to formal funding models, such as offering stock in the company or setting up a lending model with regular payments and interest.

Retirement Accounts

Another option is to borrow from your retirement plan or utilise the Rollover for Business Startups (ROBS) approach. ROBS allows entrepreneurs to invest their retirement savings into a new business venture without incurring taxes, early withdrawal penalties, or loan costs. However, it is a complex transaction that requires the guidance of a competent advisor.

When deciding how to invest in a business, it is essential to weigh the advantages and disadvantages of each option and seek appropriate financial and legal advice.

Investing in real estate

Conventional Loans

These are the most common type of real estate loan, issued by banks and financial institutions. They are not backed by any government agency, and qualifying for them requires good credit, a steady income, and a down payment of at least 20% of the property's value. Conventional loans offer lower interest rates than other loan types but are challenging to obtain due to strict eligibility criteria. The loan amount is based on the property's appraised value, and lenders require a comprehensive financial analysis of the borrower.

Hard Money Loans

Hard money loans are typically issued by private lenders and are secured by the property being purchased. They are often used for short-term financing or for borrowers with poor credit scores. Hard money loans come with higher interest rates and shorter repayment terms than other types of real estate investment loans. They are ideal for investors who need to purchase a property quickly but are not suitable for long-term investments due to their high-interest rates.

Private Money Loans

Private money loans are similar to hard money loans but are issued by individuals. They often have higher interest rates and shorter repayment terms. However, they may be more flexible and easier to obtain than traditional loans, making them ideal for investors who require quick access to funds and do not meet the eligibility criteria for conventional loans.

Commercial Loans

Commercial loans are designed for commercial real estate properties and are typically issued by banks or financial institutions. They often have higher interest rates and more stringent requirements, including extensive documentation and financial analysis. These loans are ideal for investors requiring funds for purchasing or refinancing commercial properties such as retail spaces, offices, or warehouses.

Portfolio Loans

Portfolio loans are offered by lenders who keep the loans on their balance sheet instead of selling them on the secondary market. They are used by investors who own multiple properties and need flexible financing options. Portfolio loans may have variable interest rates and more flexible repayment terms. They are ideal for investors who need to refinance multiple properties or require a line of credit to finance their investments.

Home Equity Loans

Home equity loans allow investors to finance their investment property by borrowing against the equity in their primary residence. Homeowners can borrow against the difference between their home's current market value and the mortgage balance, requiring decent credit and proof of income to qualify. However, most home equity loans demand good to excellent credit history and reasonable loan-to-value ratios.

Investing in stocks

Firstly, it is important to note that some lenders will not allow you to use a personal loan for investing in stocks. SoFi, LightStream and Upgrade, for example, explicitly exclude investing as an acceptable use of loan funds. If you do go ahead and invest, you will be in violation of the loan agreement and could be forced to pay back the full debt immediately.

If you are considering taking out a loan to invest in stocks, you should ensure that you have excellent credit and can qualify for a low APR. You should also be confident that the return on your investment will be higher than the costs of the loan, so that you can repay the loan and still make a profit.

You should also be aware that investing in stocks is a volatile business and there are no guarantees. Your investment may crash, and you will be left with the loan to pay off. You may also owe more in loan interest, fees and taxes than you earn on the investment. If you default on your loan, your credit score will take a hit.

If you are confident in your understanding of the stock market and are happy with your risk tolerance, taking out a loan to invest can be a way to boost your income. However, it is a risky strategy and you should proceed with caution.

Frequently asked questions