Intrinsic Value and Time Value of Options, Explained

Intrinsic Value and Time Value of Options, Explained


Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.

Intrinsic value and time value are two major determining factors of the value of an options contract. An option’s intrinsic value is the payoff the buyer would receive if they exercised the option right away. In other words, the intrinsic value is how profitable the option would be, based on the difference between the contract’s strike price and the market value of the underlying security.

An option’s time value is not quite as straightforward. Time value is based on a formula that includes the expected volatility of the underlying asset, as well as the amount of time until the option contract expires.

Key Points

•   Intrinsic value of an option is the profit from exercising it immediately, based on the current market value versus the strike price.

•   Time value of an option reflects its potential profitability over time until expiration.

•   The formula for intrinsic value involves subtracting the strike price from the current price of the underlying asset.

•   Time value decreases as the option nears expiration, a concept known as time decay.

•   Volatility of the underlying asset significantly impacts the time value, with higher volatility increasing the premium.

What Is the Intrinsic Value of an Option?

An investor who purchases an options contract may be buying the right, but not the obligation, to buy or sell the option’s underlying asset at an agreed-upon price, known as the strike price. Options are considered derivatives, because they are tied to the value of the underlying security. The contract may allow the investor to purchase or sell a security at that strike price at any point up until the contract expires.

There are two main kinds of options: calls and puts. The purchaser of a call option buys the right (but not the obligation) to purchase the underlying asset at a given price until a particular date.

The buyer of a put option purchases the right (but not the obligation) to sell the underlying asset at a given price until a particular date.

Important terms: In the Money, At the Money, Out of the Money

There are a few more key terms to know as it relates to options: in the money, at the money, and out of the money.

In the Money

An option is considered to be “in the money” if the investor could sell it at that moment for a profit. For a call option, that means that the price of the underlying asset is higher than the strike price specified in the options contract. For a put option to be in the money, the price of the underlying asset would have to be lower than the strike price in the contract.

At the Money

If an option is “at the money,” the price of the underlying security is equal to the strike price in the contract, and it’s not considered profitable. If an option is “out of the money,” e.g. above the market price for a call option or below the market price for a put option, the contract is also not profitable.

Out of the Money

If an option is not profitable when it expires, then it expires with no value, except for the premium. In those instances, the buyer takes a loss on the premium they paid to enter into the options contract, while the seller, or writer, of the contract collects the premium.

Recommended: Popular Options Trading Terminology to Know

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Formula for the Intrinsic Value of an Options Contract

Time to get down to the math! Here are the formulas for calculating intrinsic values of call and put options.

Intrinsic value formula for a call option:

Call Option Intrinsic Value = Underlying Stock’s Current Price – Call Strike Price

Intrinsic value formula for a put option:

Put Option Intrinsic Value = Put Strike Price – Underlying Stock’s Current Price

Example of Intrinsic Value Calculation

Imagine that hypothetical XYZ stock is selling at $48.00. A call option for XYZ with a strike price of $40 would have an intrinsic value of $8.00 ($48 – $40 = $8). So in theory, the option holder could exercise the option to buy XYZ shares at $40, then immediately sell them for a $8.00 profit in the market. Another way to phrase it: The contract would be in the money at $8.

But what if the strike price is higher than the $48.00 market price of XYZ stock? Let’s say the call option strike is $50 ($48 – $50 = –$2.00. The option would be considered out of the money and worth zero, because the intrinsic value of an option can never be negative.

What if it’s a put option? In this scenario, with an underlying price of $48.00 for XYZ stock, a put option with a strike price of $44.00 would have an intrinsic value of zero ($44 – $48 = –$4.00), again because the value of an option cannot fall below zero.

But a put option with a strike price of $50 would be considered in the money, and have an intrinsic value of $2 ($50 – $48 = $2).

While intrinsic value as a term sounds all encompassing, it isn’t. Investors should remember when calculating options strategies that an option’s intrinsic value does not include the premium the investor has to pay in order to buy the options contract in the first place. To get a better sense of the profit of an options trade, it’s important to include that initial premium, along with any other trading commissions and fees charged by the broker.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

What Is the Time Value of an Option?

When an investor buys an option, they pay in the form of a premium, or fee. When they do, that premium is typically based on the option’s intrinsic value, plus its extrinsic value. While higher volatility can result in higher premiums, time value plays a large role as well.The opportunity for an option to be profitable over time is, in essence, its time value.

The more time an investor in an options contract has, the better their chances of being able to exercise that option in the money, simply because the underlying security has a greater chance of moving in the desired direction. Longer time periods come with greater possibility for profit.

Conversely, as an options contract gets closer to expiring, its value goes down. The reason is that there is less time for the security underlying the options contract to make profitable moves.

One rule of thumb is that an option loses a third of its value during the first half of its life, and two-thirds during the second half. This phenomenon is known as the time decay of options. It’s a critical concept for options investors because the closer the option gets to expiration, the more the underlying security must move to impact the price of the option.

The intrinsic value of the option plays a role in how fast the time value of an option decays. An in-the-money option faces less dramatic time decay, because the elimination of time value takes the overall value of the option to the level of its intrinsic value. But for an out-of-the-money option, time decay is more dramatic, since the option will be entirely worthless if it expires out of the money.

Formula for the Time Value of an Options Contract

The formula for the time value of an options contract is as such:

Time Value = Option Price − Intrinsic Value

How Does Volatility Impact Time Value?

Another important factor that can impact time value is the volatility of the underlying asset.

Stocks with higher volatility typically have the potential for greater price movements — and thus related options may have a higher probability of expiring in the money. That’s one reason why time value, as reflected by the option’s premium, is typically higher when the underlying asset is more volatile.

With stocks and other assets that have lower volatility and therefore are not expected to show big price fluctuations, the time value and the option premium is likely to be lower.

Volatility, as every investor knows, cuts both ways. It can help generate gains or lead to losses.

Recommended: Implied Volatility: What It Is & What It’s Used for

How Can Intrinsic and Time Value Help Traders?

When calculating the value of the options contracts that they’re buying and selling, intrinsic value and time value can be vital to help traders gauge the potential risks and rewards of the options trade. While the intrinsic value is easy to assess, it only tells part of the story. Traders need to understand the extrinsic or time value of options as well in order to gauge how profitable the option is likely to be.Investors use this deeper understanding to inform which options trading strategies they use.

When it comes to the profitability of an options trade, investors also need to take into account the premiums they pay to buy an option, along with related commissions and fees. There are also other factors that play a role in the pricing of an options contract, such as the option’s implied volatility. This is the aspect of options pricing that takes into account the market sentiment as to the future volatility of an option’s underlying security, and can have a major influence on the price of an option as well.

💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.

The Takeaway

Understanding how options are priced is a complicated business, and knowing the two main components — intrinsic value and time value — is essential. While intrinsic value is simply the tangible face value of the contract — because it’s the amount the buyer would receive if they exercised the option right now — time value is a more complex calculation.

The time value of an option, expressed as its premium, is part of an option’s extrinsic value and it includes the volatility of the underlying asset and the time to expiration. The more volatility and the more time to the option’s expiry date, the higher the premium or value of the option.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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What Is 401(k) Matching and How Does It Work?

Matching in 401(k) retirement accounts involves an employee making a contribution to the account, and their employer mirroring that contribution — or matching it. A 401(k) is a mechanism for saving retirement funds by making pre-tax contributions through deductions from payroll.

Some plans offer a 401(k) employer match, which can be the equivalent of getting “free money” from an employer. That can help increase an investor’s retirement savings over time.

Key Points

•   401(k) matching involves employers contributing to an employee’s retirement plan, matching the employee’s contributions up to a certain limit.

•   Benefits include tax-deferred growth on investments and immediate ownership of contributions.

•   Matching rates vary, with some employers offering dollar-for-dollar matches and others a percentage.

•   Contribution limits are set annually, with additional catch-up contributions allowed for those over 50.

•   Vesting schedules determine when employees gain full ownership of employer contributions.

What Is 401(k) Matching?

Matching a 401(k) contribution means that an employer matches or mirrors an employee’s contribution to their retirement account, typically up to a certain percentage. In effect, if an employee contributes $1 to their 401(k), an employer would also contribute $1, thereby “matching” the contribution. But again, there are limits to how much employers are generally willing to match.

There are certain advantages to 401(k) matching.

For one, investment gains and elective deferrals to 401(k) plans are not subject to federal income tax until they’re distributed, which is typically when:

•   The participant reaches the age of 59 ½

•   The participant becomes disabled, deceased, or otherwise has a severance from employment

•   The plan terminates and no subsequent plan is established by the employer

•   The participant incurs a financial hardship

Second, elective deferrals are 100% vested. The participant owns 100% of the money in their account, and the employer cannot take it back or forfeit it for any reason.

And third, participants choose how to invest their 401(k). The plans are mainly self-directed, meaning participants decide how they’d like to invest the money in their account. This could mean mutual funds or exchange-traded funds (ETFs) which invest in a wide array of sectors and companies, but typically doesn’t include investing in individual companies and stocks.

Investment tactics might vary from person to person, but by understanding their goals, investors can decide whether their portfolio will have time to withstand market ups and downs with some high-risk, high-reward investments, or if they should shift to a more conservative allocation as they come closer to retirement.

💡 Quick Tip: The advantage of opening a Roth IRA and a tax-deferred account like a 401(k) or traditional IRA is that by the time you retire, you’ll have tax-free income from your Roth, and taxable income from the tax-deferred account. This can help with tax planning.

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How Does 401(k) Matching Work?

A 401(k) match is an employee benefit that allows an employer to contribute a certain amount to their employee’s 401(k) plan. The match can be based on a percentage of the employee’s contribution, up to a certain portion of their total salary or a set dollar amount, depending on the terms of the plan.

So, some employers might offer a dollar-for-dollar match, while others might offer matching based on a percentage, or a partial-match. Others may not offer any type of match.

That’s important to keep in mind: Not all employers offer this benefit, and some have prerequisites for participating in the match, such as a minimum required contribution or a cap up to a certain amount.

Meeting with an HR representative or a benefits administrator is a one way to get a better idea of what’s possible. Learning the maximum percent of salary the company will contribute is a start, then the employee can set or increase their contribution accordingly to maximize the employer match benefit.

401(k) Matching Example

Many employers use a match formula to determine their 401(k) matches (assuming they offer it at all). Some formulas are more common than others, too, which can help us with an example.

Consider this: Many 401(k) plans use a single-tier match formula, with $0.50 on the dollar on the first 6% of pay being common. But others use multi-tier match formulas, e.g., dollar-on-dollar on the first 3% of pay and $0.50 on the dollar on the next 2% of pay.

For the sake of breaking a few things down, here’s a retirement saving scenario that can illuminate how 401(k) matching works in real life:

Let’s say a person is 30 years old, with a salary of $50,000, contributing 3% of their salary (or $1,500) to a 401(k). Let’s also say they keep making $50,000 and contributing 3% every year until they’re 65. They will have put $52,500 into their 401(k) in those 35 years.

Now let’s say they opt into an employer match with a dollar-for-dollar up to 3% formula. Putting aside the likelihood of an increase in the value of the investments, they’ll have saved $105,000 — with $52,500 in free contributions from their employer.

That, effectively, is a no-cost way to increase retirement savings by 100%.

Average 401(k) Match

Average 401(k) matches is generally around 4% or 5%, and can vary from year to year. With that in mind, workers who are getting an employer match in that range, or within a broader range — perhaps 3% to 6% — are likely getting a “good” match.

But again, considering that some employers don’t offer any match at all, the chance to secure almost any type of match could be considered good for some investors.

Contribution Limits When 401(k) Matching

When deciding how much to contribute to a 401(k) plan, many factors might be considered to take advantage of a unique savings approach:

•   If a company offers a 401(k) employer match, the participant might consider contributing enough to meet whatever the minimum match requirements are.

•   If a participant is closer to retirement age, they’ll probably have a pretty good idea of what they already have saved and what they need to reach their retirement goals. An increase in contributions can make a difference, and maxing out their 401(k) might be a solid strategy.

A retirement calculator can also be helpful in determining what the right contribution amount is for a specific financial situation.

In addition to the uncertainty that can come with choosing how much to contribute to a 401(k), there’s the added pressure of potential penalties for going over the maximum 401(k) contribution limit.

Three common limits to 401(k) contributions:

1.    Elective deferral limits: Contribution amounts chosen by an employee and contributed to a 401(k) plan by the employer. In 2024, participants can contribute up to $23,000. In 2024, participants can contribute up to $23,000. In 2023, participants can contribute up to $22,500.

2.    Catch-up contribution limits: After the age of 50, participants can contribute more to their 401(k) with catch-up contributions. In 2024 and 2023, participants can make up to $7,500 in catch-up contributions.

3.    Employer contribution limits: An employer can also make contributions and matches to a 401(k). The combined limit (not including catch-up contributions) on employer and employee contributions in 2024 is $69,000 and in 2023 is $66,000.

If participants think their total deferrals will exceed the limit for that particular year, the IRS recommends notifying the plan to request the difference (an “excess deferral”) “be paid out of any of the plans that permit these distributions. The plan must then pay the employee that amount by April 15 of the following year (or an earlier date specified in the plan).”

💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

401(k) Vesting Schedules

Vesting ” means “ownership” in a retirement plan. The employee will vest, or own, some percent of their account balance. In the case of a 401(k), being 100% vested means they’ve met their employer’s vesting schedule requirements to ensure complete ownership of their funds.

Vesting schedules, determined by 401(k) plan documents, can lay out certain employer vesting restrictions that range from immediate vesting to 100% vesting after three years to a schedule that increases the vested percentage based on years of service. Either way, all employees must be 100% vested if a plan is terminated by the employer or upon reaching the plan’s standard retirement age.

Tips on Making the Most of 401(k) Matching

Here are some things to keep in mind when trying to make the most of 401(k) matching.

Remember: It’s “Free” Money

An employer match is one part of the overall compensation package and another way to maximize the amount of money an employer pays their employees. Those employees could be turning their backs on free money by not contributing to an employer-matched 401(k) plan.

You Can Reduce Taxable Income

According to FINRA, “with pre-tax contributions, every dollar you save will reduce your current taxable income by an equal amount, which means you will owe less in income taxes for the year. But your take-home pay will go down by less than a dollar.”

If a participant contributed $1,500 a year to a 401(k), they’d only owe taxes on their current salary minus that amount, which could save some serious money as that salary grows.

Every Dollar Counts

It can be tempting to avoid contributing to your retirement plan, and instead, use the money for something you want or need now. But remember: The more time your money has to potentially grow while it’s invested, the more likely you are to reach your financial goals sooner. While that’s not guaranteed, every dollar you can save or invest now for future use is a dollar you don’t need to save or invest later.

The Takeaway

A 401(k) match is an employee benefit that allows an employer to contribute a certain amount to their employee’s 401(k) plan. Matches can be based on a percentage of the employee’s contribution, up to a certain portion of their total salary or a set dollar amount, depending on the terms of the plan.

Taking advantage of employer matches in a 401(k) plan can help workers reach their financial goals sooner, as a match is, in effect, “free money.” If you’re considering how matches can help bolster your investment strategy, it may be worth discussing with a financial professional.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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FAQ

How much should I match 401(k)?

It’ll be up to the individual investor, but to make the most of a 401(k) match, workers should likely try to contribute as much as possible up to their employer’s match — it may be worth discussing with a financial professional for additional guidance.

What does 6% 401(k) match mean?

A 6% 401(k) match means that an employer is willing to match up to 6% of an employee’s total salary or compensation in their 401(k) account through matching contributions.

What is a good 401(k) match?

A good 401(k) match could be in the 3% to 6% range, as average employer matches tend to be between 4% and 5%.

Is a 3% match good? Is a 4% match good?

Generally speaking, a 3% match could be considered “good,” as could a 4% match. On average, employers match somewhere between 4% and 5%, and when you get down to it, almost any employer match is “good.”

How do I maximize my 401(k) match?

Maximizing your 401(k) match involves contributing enough to get at least your employer’s full match, whatever that match may be. You should be able to change your contribution levels through your provider, or by speaking with your employer.


SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Active vs Passive Investing: Differences Explained

Key Points

•   Active investing strategies often underperform the market over time, while passive strategies tend to outperform.

•   Active funds typically have higher fees, which can lower returns, while passive funds have lower fees.

•   Active investing relies on human intelligence and skill to capture market upsides, while passive investing relies on algorithms to track market returns.

•   Active investing is generally less tax efficient, while passive investing is typically more tax efficient.

•   Passive investing may be less tied to market volatility, while active investing is more vulnerable to market shocks.

Active investing vs. passive investing generally refers to the two main approaches to structuring mutual fund and exchange-traded fund (ETF) portfolios. Active investing is a strategy where human portfolio managers pick investments they believe will outperform the market — whereas passive investing relies on a formula to mirror the performance of certain market sectors.

Which approach is better, active investing vs. passive? There seems to be no end to this debate, but there are factors that investors can consider — especially the difference in cost. Because active investing typically requires a team of analysts and investment managers, these funds are more expensive and come with higher expense ratios. Passive funds, which require little or no involvement from live professionals because they track an index, cost less.

Also, there is a body of research demonstrating that indexing typically performs better than active management. When you add in the impact of cost — i.e. active funds having higher fees — this also lowers the average return of many active funds. Following are a few more factors to consider when choosing active investing vs. passive strategies.

Active vs Passive Investing: Key Differences

The following table recaps the main differences between passive and active strategies.

Active Funds

Passive Funds

Many studies show the vast majority of active strategies underperform the market on average, over time. Most passive strategies outperform active ones over time.
Higher fees can further lower returns. Lower fees don’t impact returns as much.
Human intelligence and skill may capture market upsides. A passive algorithm captures market returns, which are typically higher on average.
Typically not tax efficient. Typically more tax efficient.
Potentially less tied to market volatility. Tied to market volatility and more vulnerable to market shocks.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

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Active Investing Definition

What is active investing? Active investing is a strategy where an investor attempts to beat the market by trading individual stocks, bonds, or other securities.

With active investing, either an individual investor could be the one trading securities in their own portfolios, or portfolio managers of actively managed exchange-traded funds (ETFs) and mutual funds could be the one buying and selling assets to outperform the market or a specific sector.

Active investors and actively-managed funds often trade stocks and securities to profit in the short term. Short-term trading, like day trading, can be difficult as it requires the investor to be an expert on the financial markets and the factors impacting stock prices. It also requires the investor to have a good deal of discipline, as short-term stock picking can be a volatile and risky endeavor.

Active Investing Pros and Cons

Active investing is what live portfolio managers do; they analyze and then select investments based on their growth potential. Active strategies have a number of pros and cons to consider when comparing them with passive strategies.

Pros and Cons of Active Investing

Pros

Cons

May be fun to follow the market and make your own investment decisions Difficult to beat the market
May profit in up, down, and sideways markets Time consuming
Can tailor a strategy based on your goals and risk tolerance Higher fees and commissions

Pros

•   One potential advantage of having a real person crunching numbers and making investment decisions is that they may be able to spot market opportunities and take advantage of them. A computer algorithm is not designed to pivot the way a human can, which might benefit the performance of an actively managed ETF or mutual fund.

•   Whereas a passive strategy is designed to follow one market sector index (e.g. the performance of large cap U.S. companies via the S&P 500® index), an active manager can be more creative and is not limited to a single sector.

•   The number of actively managed mutual funds in the U.S. stood at about 6,585 as of June 2023 vs. 517 index funds, according to Statista. Given that there are many more active funds than passive funds, investors may be able to select active managers who have the kind of track record they are seeking.

Cons

•   The chief downside of active investing is the cost. Hedge funds and private equity managers are one example, charging enormous fees (sometimes 10%, 15%, 20% of returns) for their investing acumen.

But even standard actively managed funds, which may charge 1% or 1.5% or even 2% annually, are far higher than the investment fees of most passive funds, where the annual expense ratio might be only a few basis points.

•   The majority of active strategies don’t generate higher returns over the long haul. According to the well-known SPIVA (S&P Indices vs. Active) 2022 year end scorecard report, 95% of U.S. active equity funds underperformed their respective S&P indexes over the last two decades. So investors who are willing to pay more for the insight and skill of a live manager may not reap the rewards they seek.

•   A professional manager may create more churn in an actively managed fund, which could lead to higher capital gains tax.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

Passive Investing Definition

Passive investing strategy is when an investor buys and holds a mix of assets for an extended period. Many passive investors will invest in passively-managed index funds, which attempt to replicate the performance of a benchmark index. Passive investors are not necessarily trying to beat the market.

Passive Investing Pros and Cons

The term “passive investing” may not have a strong positive connotation, yet the funds that follow an indexing strategy typically do well vs. their active counterparts.

Pros

•   Passive strategies are more transparent. Because index funds simply track an index like the S&P 500 or Russell 2000, there’s really no mystery how the constituents in the fund are selected nor the performance of the fund (both match the index).

•   As noted above, index funds outperformed 79% of active funds, according to the SPIVA scorecard.

•   Passive strategies are generally much cheaper than active strategies.

•   Passive strategies can be more tax efficient as there is generally much less turnover in these funds.

Cons

•   Because passive funds use an algorithm to track an existing index, there is no opportunity for a live manager to intervene and make a better or more nimble choice. This could lead to lost opportunities.

•   Passive strategies are more vulnerable to market shocks, which can lead to more investment risk.

Which Should You Pick: Active or Passive Investing?

Deciding between active and passive strategies is a highly personal choice. It comes down to whether you believe that the active manager you pick could be among the few hundred who won’t underperform their benchmarks; and that the skill of an active manager is worth paying the higher investment costs these strategies command.

You could also avoid treating the active vs. passive investing debate as a forced dichotomy and select the best funds in either category that suit your goals.

The Takeaway

Active vs. passive investing is an ongoing debate for many investors who can see the advantages and disadvantages of both strategies. Despite the evidence suggesting that passive strategies, which track the performance of an index, tend to outperform human investment managers, the case isn’t closed.

After all, passive investing may be more cost efficient, but it means being tied to a certain market sector — up, down, and sideways. That timing may or may not work in your favor. Active investing costs more, but a professional may be able to seize market opportunities that an indexing algorithm isn’t designed to perceive.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


Invest with as little as $5 with a SoFi Active Investing account.

FAQ

What is the difference between active and passive investing?

The main difference between active and passive investing is that active investing is when a portfolio manager — or the investor themselves — manages their portfolio, buying and selling investments to try to outperform the market. Passive investing is when an investor buys assets and holds onto them for a long period. Passive investing usually means investing in index funds, which track the performance of an index.

What are the examples of active funds?

According to a Morningstar February 2024 analysis, some examples of actively managed ETFs include the Avantis U.S. Equity ETF (AVUS), the Capital Group Dividend Value ETF (CGDV), and the Dimensional Core U.S. Equity 1 ETF (DCOR). Note that these are just examples. An investor should always do their own research before making any investments.

Does active investing have high risk?

Active investing is considered higher risk. Active investors and actively-managed funds often trade stocks and securities to profit in the short term. Short-term trading typically requires knowledge about financial markets and the factors impacting stock prices. It can be volatile and risky.

Should I invest in active or passive funds?

Deciding whether to invest in active or passive funds is a personal choice that only you can make. It depends on your personal situation, goals, and risk tolerance, among other factors. In general, passive investing is better for beginners, and active investing is better for experienced investors with knowledge of the market and who understand the risk involved.

Are ETFs active or passive?

ETFs can be active or passive. Passive ETFs track indexes such as the S&P 500 and may make sense for investors pursuing a buy and hold strategy. Active ETFs rely on portfolio managers to select and allocate assets in an effort to try to outperform the market.


Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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A Walkthrough of What Leverage Trading Is

Understanding Leverage Trading

Leverage allows investors to allocate a small amount of capital to get exposure to a much bigger position. Leverage, also called margin, is effectively a way of borrowing cash for increased trading power. A leverage ratio of 20:1 means a $1 investment can buy $20 worth of an asset.

Using leverage, traders can place bigger bets and potentially earn higher returns on their initial capital. However, leveraged trading also increases a trader’s risk of losses; if the asset moves in the wrong direction, the trader not only suffers a loss but must repay the amount borrowed, plus interest and fees.

This is one reason that only experienced investors qualify for leverage accounts, e.g. margin accounts, and leveraged trading opportunities.

Key Points

•   Leverage trading involves using borrowed funds to increase potential investment returns.

•   A leverage ratio of 20:1 means a small investment can control a much larger position.

•   Risks include the potential to lose more than the initial investment.

•   Not all securities are eligible for leverage; rules vary by broker and security type.

•   Leverage is typically reserved for experienced investors due to its high risk.

What Is Leverage Trading?

In both business and finance, the term leverage refers to the use of debt to fuel expansion or purchase securities. In leverage trading, traders can use margin to buy assets like stocks, options, and forex.

Leverage and margin are similar concepts, but they’re different. One way to think of the differences is that a trader can use margin to increase their leverage. Margin is the tool, and leverage is the force behind the tool, which can be used to potentially increase returns (or losses).

A margin account allows you to borrow from the brokerage to purchase securities that are worth more than the cash you have on hand. In this case, the cash or securities already in your account act as collateral.

Which Securities Are Eligible for Margin?

Not all securities can be bought using leverage, however. Industry rules dictate that equities known as penny stocks and Initial Public Offering (IPO) stocks are not marginable. Generally, stocks and exchange-traded funds (ETFs) that are worth more than $3 per share, as well as mutual funds and certain types of bonds are eligible for leverage trades using margin. Check with your broker, as rules can vary by jurisdiction.

Margin can be used to trade options and futures, but this type of leverage trading can be highly risky. Forex options trading, for example, allows traders to place big bets using very small amounts of cash.

While there is no standard amount of margin in the forex market, it is common for traders to post 1% margin, which allows them to trade $100,000 of notional currency for every $1,000 posted — a ratio of 100:1.

Leverage Risks and Rewards

Leverage trading can only be successful if the return on an investment is higher than the cost to borrow money, which you must repay with interest and fees.

Leverage trading can significantly increase potential earnings, but it is also very risky because you can lose more than the entire amount of your investment. For that reason leverage is usually only available to experienced traders.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Increase your buying power with a margin loan from SoFi.

Borrow against your current investments at just 11%* and start margin trading.

*For full margin details, see terms.


How Leverage Works in Trading

Leverage trading in a brokerage account consists of a trader borrowing money from the broker, then using that along with their own funds to enter into trades.

The key to understanding how using leverage can help generate higher returns, but also greater losses, is that the funds borrowed are a fixed liability. Suppose a trader starts with $50, and borrows $50 to buy $100 worth of stock. Whether the stock’s value goes up or down from there, the trader is on the hook to give back $50, plus interest, to the broker.

Example of Leverage Trading

Using the above example, suppose the stock appreciates by 10%, and the trader closes out the position. They return the $50 they borrowed, and keep the remaining $60. That equates to a $10 gain on their $50 of capital, and a 20% return — double the return of the underlying stock.

On the flip side, consider what happens if the stock declines in value by 10%. The trader closes out the position and receives $90, but has to give the broker back the $50 they borrowed, plus interest. They are left with $40, a loss of $10, plus any interest or fees, which is a 20% loss or more.

Understanding Leverage Ratio

Leverage is often expressed as a ratio. For example, a leverage ratio of 2:1 is generally the rule for using margin for equity trades. If you have $50, you can buy $100 worth of stock.

In the case of other types of securities, the leverage ratio can be much higher. A leverage ratio of 20 means a $1,000 investment would allow you to open a trading position of $20,000; 50:1 would allow you to take a position of $50,000.

Maximum Leverage

Brokers have limits on how much they’ll lend traders based on the amount of funds the trader has in their account, their own regulations, and government regulations around leverage trading. If you’re considering using leverage, be sure to understand the rules.

•   Stocks. Thanks to the Federal Reserve Board’s Regulation T, plus a FINRA rule governing margin trades in brokerage accounts, the maximum you can borrow is 50% for an equity trade.

•   Forex. The foreign currency market tends to allow greater amounts of leverage. In some cases, you can place bets as high as 100:1 in the U.S.

•   Commodities. Commodities rules around maximum leverage, and leverage ratios can fluctuate based on the underlying.

Types of Leverage Trading

There are a few different types of leverage trading, each with similarities and differences.

Trading on Margin

Margin is money that a trader borrows from their broker to purchase securities. They use the other securities in their account as collateral for the loan. If their leveraged trade goes down in value, a trader will need to sell other securities to cover the loss.

Many brokers charge interest on margin loans. So in order for a trader to earn a profit, the security has to increase in value enough to cover the interest.

Leveraged ETFs

Some ETFs use leverage to try and increase potential gains based on the index they track. For example, there is an ETF that specifically aims to return 3x the returns that the regular S&P 500 index would get.

It’s important to note that most funds reset on a daily basis. The leveraged ETF aims to match the single day performance of the underlying index. So over the long term even if an index increases in value, a leveraged ETF might decrease in value.

Derivatives

Traders can also use leverage trading with derivatives and options contracts. Buying a single options contract lets a trader control many shares of the underlying security — generally 100 shares — for far less than the value of those 100 shares. As the underlying security increases or decreases in value, the value of the options contract changes.

Options are derivatives contracts that give buyers the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) an asset at a specified price within a certain period of time. Traders can choose to sell call options on a stock if they think it is going to decrease in value.

Options trading is one of the riskiest types of leverage trading. A trader could potentially lose an unlimited amount of money if they sell a call option and the underlying stock price skyrockets in value.

If the option seller exercises the trade, the trader will have to purchase the associated amount of the underlying security to sell to the option seller. If the security has gone up a significant amount this could cost millions of dollars or more.

Recommended: Options Trading 101

Leverage Trading Terms to Know

There are several key terms to know in order to fully understand leverage trading.

Account balance: The total amount of funds in a trader’s account that are not currently in trades.

Buying power: This is the total amount a trader has available to enter into leverage trades, including both their own capital and the amount they can borrow.

Coverage: The ratio of the amount of funds currently in leveraged trades in one’s account to the net balance in their account.

Margin Requirement: This is the amount of funds a broker requires a trader to have in their margin account when entering into leverage trades. If a trader incurs losses, those funds will be used to cover them. Traders can also use securities they hold in their account to cover losses. Margin requirement is often a percentage. For example, at a leverage amount of 100:1, the margin requirement is 1%.

Margin call: If a trader’s account balance falls below the margin requirement, the broker will issue a margin call. This is a warning telling the trader they have to either add more funds to their account or close out some of their positions to meet the minimum margin requirement. The broker does this to make sure the trader has sufficient funds in their account to cover potential losses.

Used margin: When an investor enters into trades, some of their account balance is held by the broker as collateral in case it needs to be used to cover losses. That amount will only be available for the trader to use after they close out some of their positions.

Usable margin: This is the money in one’s account that is currently available to put into new trades.

Open position: When a trader is currently holding an asset they are in an open position. For instance, if a trader owns 100 shares of XYZ stock, they have an open position on the stock until they sell it.

Close position: The total value of an investment at the time the trader closes it out.

Stop-loss: Traders can set a price at which their asset will automatically be sold in order to prevent further losses if its value is decreasing. This is very useful if a trader wants to hold positions overnight or if a stock is very volatile.

Pros and Cons of Leveraged Trading

On the surface, leverage can sound like a powerful tool for investors — which it can be. But it’s a tool that can cut both ways: Leverage can add to buying power and potentially increase returns, but it can also magnify losses, and put an investor in the hole.

Pros of Leverage

Cons of Leverage

Increases buying power Leverage funds must be repaid, with interest
Potential to earn higher returns Potential to lose more than your initial investment
Relatively easy to use, if you qualify Investors must meet specific criteria in order to use leverage or open a margin account

Pros

Using leverage can increase your trading power, sometimes to a large degree. It’s important to know the rules, as leverage ratios vary according to the securities you’re trading, the jurisdiction you’re in, and sometimes your broker’s discretion.

If you meet the criteria for using leverage or opening a margin account to trade, it’s relatively easy to access the funds and open bigger positions. Sometimes, placing that bigger bet can pay off with a much higher return than you would have gotten if you invested just the capital you had on hand.

Cons

Just as using leverage can amplify gains, it can amplify losses — in some cases to the point where you lose your initial investment, you must repay the money you borrowed, and you may owe fees and interest on top of that.

For that reason, many brokers require investors to meet certain criteria before they can place leveraged trades.

Tips for Managing the Risks of Leveraged Trading

Experience and skill can help you manage the risk factors inherent in leveraged trades, and a couple of basic protective strategies may help.

Hedge Your Bets

It might be possible to hedge against potential losses by taking an offsetting position to the leverage trade.

Limit Potential Loss of Capital

One rule of thumb suggests that traders limit their loss of capital to no more than 3% of the actual cash portion of the trade. While it’s difficult to know the exact risk level.

Decide Whether Leverage Trading Is Right for You

Although there is potential for significant earnings using leverage trading, there is no guarantee of any earnings, and there is also potential for significant loss. For this reason leverage trading is often said to be best left to experienced traders.

If an investor wants to try leverage trading it’s important for them to assess their financial situation, figure out how much they’re willing to risk, and conduct detailed analysis of the securities they are looking to trade.

Setting up a stop-loss order may help decrease the risk of losses, and traders can also set up a take-profit order to automatically take profits on a position when it reaches a certain amount.

The Takeaway

Leveraged trading is a popular strategy for investors looking to increase their potential profits. By using borrowed funds it’s possible to take much bigger positions, and possibly see bigger wins. But using leverage is very risky, and you can lose more than you have (because the money you borrow has to be repaid in full, plus interest).

If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.

Get one of the most competitive margin loan rates with SoFi, 11%*

FAQ

What leverage is good for $100?

If you only wanted to invest a small amount of capital, say $100, you would first need to check the policies at your brokerage about the use of lower amounts. If approved, you might want to use a lower amount of leverage, e.g. 10:1. That means for every $1 of cash you put down, you can get $10 in leverage. So a $100 leverage trade would be worth $1,000.

How much leverage is too high?

Knowing how much you can afford to lose is an important calculation when making leveraged trades. In addition, the amount of leverage available to you will also be restricted by existing regulations or brokerage rules. And remember, if a trade goes south, your broker can liquidate existing assets to cover your losses and any margin.


Photo credit: iStock/ljubaphoto

*Borrow at 11%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

Fund Fees
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.
SoFi Invest may waive all, or part of any of these fees, permanently or for a period of time, at its sole discretion for any reason. Fees are subject to change at any time. The current fee schedule will always be available in your Account Documents section of SoFi Invest.


Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.


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What Is Private Credit?

Private credit refers to lending from non-bank financial institutions. Also referred to as direct lending, private credit allows borrowers (typically smaller to mid-sized businesses) to seek financing through avenues other than a standard bank loan.

This type of arrangement can remove barriers to funding for businesses while creating opportunities for investors, as a type of alternative investment. Private credit funds allow institutional and individual investors to pool capital that is used to extend loans and generate returns through interest on those loans.

Key Points

•   Private credit refers to lending from non-bank financial institutions, providing financing options for businesses outside of traditional bank loans.

•   Private credit investments can include senior lending, junior debt, mezzanine debt, distressed credit, and specialty financing, each with different risk levels and repayment priorities.

•   Private credit offers potential benefits such as income and return potential, diversification, and supporting business growth.

•   However, investing in private credit carries risks, including borrower default, illiquidity, and potential challenges in underwriting and due diligence.

•   Retail investors can access private credit through private credit funds, but eligibility criteria, such as being an accredited investor, may apply.

What Are the Different Types of Private Credit?

Private credit investments can adhere to various investment strategies, each offering a different level of risk and rewards. Within a capital structure, certain types of private credit take precedence over others regarding the order in which they’re repaid.

Senior Lending

In a senior lending arrangement, secured loans are made directly to non-publicly traded, middle-market companies. These loans sit at the top of the capital structure or stack and assume priority status for repayment should the borrowing company file for bankruptcy protection.

Senior debt tends to have lower interest rates than other types of private credit arrangements since the loan is secured by business collateral. That means returns may also be lower, but the preferred repayment status reduces credit risk for investors.

Should the borrowing company fail, senior loans would hold an initial claim on the business’s assets. Those may include cash reserves, equipment and property, real estate, and inventory. That significantly reduces the risk of investors losing their entire investment in the event of bankruptcy.

Junior Debt

Junior or subordinated debt is debt that follows behind senior lending obligations in the capital stack. Loans are made directly to businesses with rates that are typically higher than those assigned to senior debt. Junior debt is most often unsecured though lenders can impose second lien requirements on business assets.

Investors may generate stronger returns from junior debt, but the risk is correspondingly higher. Should the borrowing business go bankrupt, junior debts would only be repaid once senior financing obligations have been satisfied.

Mezzanine Debt

Mezzanine debt is a private credit term that’s often used interchangeably with junior debt, but it has a slightly different meaning. In mezzanine lending, the lender may have the option to convert debt to equity if the company defaults on repayment. There may be some collateral offered but lenders also consider current and future cash flows when making credit decisions.

Compared to junior or senior debt, mezzanine debt is riskier but it has the potential to produce higher yields for investors as the interest rates are usually higher. The risk to borrowers is that if the company defaults, they’ll be forced to give up an ownership share in the business.

Distressed Credit

Distressed credit is extended to companies that are experiencing financial or operational stress and may be unable to obtain financing elsewhere. The obvious benefit to investors is the possibility of earning much higher returns since this type of private credit generally carries higher rates. However, that’s balanced by a greater degree of risk.

Risk may be mitigated if the company can effectively utilize private credit capital to restructure and stabilize cash flow. Should the company eventually file for bankruptcy protection, distressed debt investors would take precedence over equity holders for repayment.

Special Financing

Specialty financing refers to lending that serves a specific purpose and doesn’t fit within the confines of traditional bank lending. This type of private credit is also referred to as asset-based financing since lending arrangements typically involve the acquisition of an asset that is used as collateral for the loan.

Equipment financing is one example. Say that a construction business needs to purchase a new backhoe. They could get an equipment loan to buy what they need, using the backhoe they’re purchasing to secure it.

💡 Quick Tip: While investing directly in alternative assets often requires high minimum amounts, investing in alt funds through a mutual fund or ETF generally involves a low minimum requirement, making them accessible to retail investors.

Alternative investments,
now for the rest of us.

Start trading funds that include commodities, private credit, real estate, venture capital, and more.


Potential Benefits of Investing in Private Credit

Private credit investing can be an attractive option for investors who are interested in diversifying their portfolios with alternative investments. Here are some of the primary reasons to consider private credit as an asset class.

Income Potential

Private credit can provide investors with current income if they’re collecting interest payments and fees on an ongoing basis. The more private credit investments someone holds in their portfolio, the more opportunities they have to generate regular cash flow.

Return Potential

Investing in private credit may deliver returns at a level well above what you might get with a standard portfolio of stocks, bonds, and mutual funds. The nature of private credit is such that borrowers may expect to pay higher interest rates than they would for a traditional bank loan. That, in part, is a trade-off since private credit offers lower levels of liquidity than other investments.

Investors benefit as long as borrowers repay their debt obligations on time. The exact return profile of any private credit investment depends on the interest rate the lender requires the borrower to pay, which can directly correspond to their risk profile and where the debt is situated in the capital stack.

Diversification

Like other alternative investments, private credit can introduce a new dimension into a portfolio, allowing for greater diversification of that portfolio. Private credit tends to have a lower correlation with market movements than stocks or bonds, which may help insulate investors against market volatility, to a degree.

Additionally, investors have an opportunity to diversify within the private credit segment of their portfolios. For example, an investor may choose to invest in a mix of senior lending, mezzanine debt, and specialty financing to spread out risk and generate varying levels of returns.

What Are the Risks of Investing in Private Credit?

Like any other investment, private credit can present certain risks to investors. Weighing those risks against the potential upsides can help determine whether private credit is the right investment for you.

Borrower Default

Perhaps the most significant risk factor associated with private credit investments is borrower default. Should the borrower fail to repay their debt obligations, that can put the value of your investment in question. In a worst-case scenario, you may be forced to wait out the resolution of a bankruptcy filing to determine how much of your investment you’ll be able to recover.

Again, it’s important to remember that borrowers who seek private credit may have been turned down for traditional bank financing elsewhere. So, your credit risk has already increased. If you have a lower risk tolerance overall, private credit may not be the best fit for your portfolio.

Illiquidity

Private credit investments are less liquid than other types of investments since they operate on a fixed term. It can be difficult to exit these investments ahead of schedule without facing the possibility of a sizable loss if you’re forced to sell at a discount.

In that sense, private credit investments are similar to bonds which also lock investors in for a preset period. For that reason, it’s important to consider what type of time frame you’re looking for when making these investments.

Recommended: Short-Term vs Long-Term Investments

Underwriting

While banks often have strict underwriting requirements that borrowers are expected to meet, private credit allows for more flexibility. Lenders can decide who to extend credit to, what collateral to require if any, and what terms a borrower must agree to as a condition of getting a loan.

That’s good for borrowers who may have run into trouble getting loans elsewhere, but it ups the risk level for investors. If you’re investing in private credit funds that are less transparent when it comes to sharing their underwriting processes or detailed information about the borrower, that can make it more difficult to make an informed decision about your investments.

Ways to Invest in Private Credit

Private credit has traditionally been the domain of institutional investors, though retail investors may be able to unlock opportunities through private credit funds.

These funds allow investors to pool their capital together to make investments in private credit, similar to the way a traditional mutual fund or hedge fund might work. You’ll need to find an investment company or bank that offers access to private credit investments, including private credit funds, funds if you’re interested in adding them to your portfolio.

One caveat is that private credit investments may only be open to selected retail investors, specifically, those who meet the SEC’s definition of an accredited investor, who is someone that fits the following criteria:

•   Has a net worth of $1 million or more, excluding their primary residence

•   Reported income over $200,000 individually or $300,000 with a spouse or partner for the previous two years and expects to have income at the same level or higher going forward

Investment professionals who hold a Series 7, Series 65, or Series 82 securities license also qualify as accredited.

💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Who Should Invest in Private Credit?

Given its risk profile, private credit may not be an appropriate investment choice for everyone. In terms of who might consider private credit investments, the list can include people who:

•   Are interested in diversifying their portfolios with alternative investments.

•   Can comfortably assume a higher level of risk for an opportunity to generate higher returns.

•   Understand the time commitment and the risks involved.

•   Would like to support business growth through their investments.

•   Meet the requirements for a private credit investment (i.e., accredited status, minimum buy-in, etc.)

Private credit investments may be less suitable for someone who’s hoping to create some quick returns or is more risk-averse.

How Does Private Credit Fit in Your Portfolio?

If you’re able to invest in private credit, it’s important to consider how much of your portfolio you’d like to allocate to it. While you might be tempted to devote a larger share of your investment dollars to private credit, it’s wise to consider how doing so might affect your overall risk exposure.

Choosing a smaller allocation initially can allow you to test the waters and determine whether private credit investments make sense for you. That can also minimize the amount of risk you’re taking on as you explore new territory with your investments.

When evaluating private credit funds, it’s helpful to consider the fund manager’s track record and preferred investment strategy. A more aggressive strategy may yield better returns but it may mean accepting more risk, which you might be uncomfortable with. Also, take a look at what you might pay in management fees as those can directly impact your net return on investment.

The Takeaway

Private credit is a form of financing sought outside of traditional bank loans. For investors, it may be classified as an alternative investment, and it has its pros and cons in an investor’s portfolio.

Private credit can benefit investors and businesses alike, though in different ways. If you’re an accredited investor, you may consider private credit along with other alternative investments to round out your portfolio. Evaluating the risks and the expected rewards from private credit investing can help you decide if it’s worth exploring further.

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FAQ

Is Investing in Private Credit Worth It?

Investing in private credit could be worth it if you’re comfortable with the degree of risk that’s involved and the expected holding period of your investments. Private credit investing can deliver above-average returns while allowing you to diversify beyond stocks and bonds with an alternative asset class.

What’s the Difference Between Private Credit and Public Credit?

Public credit refers to debt that is issued or traded in public markets. Corporate bonds and municipal bonds are two examples of public credit. Private credit, on the other hand, originates with private, non-bank lenders and is extended to privately-owned businesses.

Why is Private Credit Popular?

Private credit is popular among businesses that need financing because it can offer fewer barriers to entry than traditional bank lending. Among investors, private credit has gained attention because of its return potential and its use as a diversification tool.

What Is the Average Return on Private Credit?

Returns on private credit investments can vary based on the nature of the loan agreement. When considering private credit investments it’s important to remember that the higher the return potential, the greater the risk you may be taking on.

Is Private Credit a Loan?

Private credit arrangements are loans made between a non-bank entity and a privately owned business. These types of loans allow companies to raise the capital they need without having to meet the requirements that traditional bank lenders set for loans.


Photo credit: iStock/Adene Sanchez

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