How to use debt to build wealth
There are two primary schools of thought on debt. The first is the Dave Ramsey camp. Ramsey hates debt. He believes consumers should avoid it.
The only one who benefits, according to Ramsey, is the lender.
On the other extreme, we have people like Robert Kiyosaki. For his part, Kiyosaki maintains that debt can be used to make us wealthier. According to him, not all debt is bad.
The truth is, both are right ... at times. Used responsibly, debt can be a powerful tool. But used haphazardly or irresponsibly, debt can harm your financial situation.
So, how can you ensure debt doesn’t drain your bank account? More importantly, how can you use debt to build wealth?
Debt is simply borrowed money paid back with interest. So, when considering debt costs, you must factor in the loan's interest rates, fees, and duration.
Debt is typically divided into one of two main categories.
- Secured debt: This type of debt is backed by an asset, like your house. This asset is known as collateral. In the event you cannot repay the debt, the lender can sell the collateral to recoup some or all of the outstanding loan.
- Unsecured debt: This type of debt is not backed by collateral. Most credit cards are examples of unsecured debt. That is, no asset needs to be pledged to obtain access to the credit.
All else equal, diligently paying off debt leads to a higher credit score—which results in more favorable loan terms (i.e., lower interest rates).
Leveraging debt for investments
Debt can be an effective way to accelerate the returns in your portfolio, but there's no guarantee. It's also riskier than investing cash you didn’t borrow.
For example, imagine you have $1,000 in your brokerage account and decide to invest in shares of company XYZ. Unfortunately, XYZ goes bankrupt six months later, and your stock position drops to $0.
In the end, you lost $1,000 on the trade.
Now, imagine, instead, you have no money in your brokerage. You decide to borrow $1,000 and invest the cash into XYZ stock. Similarly, the company goes bankrupt six months later, and you lose your entire investment.
Despite losing the $1,000, you still need to repay it, plus interest. If you don’t have the means to cover the loan, you could find yourself in a precarious situation.
This is why borrowing to fund investments is riskier than using your savings. But it can also be more lucrative.
If the stock price of XYZ appreciated sufficiently, you could pay off your loan and keep the difference. Imagine instead of dropping to $0, your position in XYZ rises to $1,500. You could pay the brokerage back their $1,000 (plus interest) and pocket the difference.
Or, using the first example, you could use $1,000 of your own money and $1,000 of borrowed money to boost your potential return. Instead of turning $1,000 into $1,500, you could turn $2,000 into $3,000.
Typical examples of using debt to build wealth
- Real estate: One of the most common ways some of the wealthiest people became rich is through real estate investments. In fact, nearly a third (32%) of the wealth of high-net-worth individuals is in real estate, more than they invest in the stock market (26%). Purchasing a property using a mortgage can provide recurring income and, ultimately, a potentially appreciating asset.
- Margin trading: Borrowing money from a brokerage to buy stocks is called margin trading. In this instance, the stocks are used as collateral. Should the investment fall too much, the brokerage may demand additional funding. This event is known as a margin call. Sometimes, the broker may force the sale of stocks purchased on margin to cover funding requirements.
- Small business financing: Many individuals have made their wealth through successful business ventures. In many cases, these businesses would not have been possible without securing a small business loan. Banks provide these funds, expecting the company to generate profits that exceed the cost of the loan.
- Education: Post-secondary education can help you land a lucrative career that would otherwise be impossible to secure, like becoming a corporate lawyer. For many individuals, a university education is only feasible through a loan. The average annual income for a high school graduate in the United States is $39,976. On the other hand, those with a bachelor’s degree earn, on average, $80,478 or more.
Using debt to build wealth in practice
You understand how debt can be used to finance investments, but what does it look like in practice?
Imagine John, age 31, has a stable job and a steady paycheck. One day, Jonas decides to purchase a rental property to earn more income.
Over the last couple of years, Jonhn has diligently accumulated $25,000 in savings. Unfortunately, the property he wants to purchase costs $100,000.
As a result, he takes out a mortgage for $75,000 to make up the difference. Luckily he enjoys an exceptional credit score and obtains the loan at a competitive rate. John's mortgage payment is $500 per month, which includes principal and interest.
After closing the deal, he finds a tenant willing to rent the property for $1,000 per month. This means John will receive $12,000 per year in rental income. Of this, $6,000 will be paid to the bank ($500 mortgage payment x 12 months).
John pockets the difference of $6,000 in income every year.
Because of the strong housing market, his rental property appreciates by 50% over the next four years. In addition to the ongoing income, John now has an asset valued at $150,000.
That's not all. After a few years of paying his mortgage, the principal amount of the loan has decreased to $60,000. Recall he initially borrowed $75,000.
If John chooses to, he can sell the property for $150,000 (current market value) and pay the bank the remaining amount owed on the mortgage ($60,000).
Consequently, John could walk away with the difference of $90,000. And this is to say nothing of the $24,000 in net rental income he’s collected over the past four years ($6,000 x 4 years).
None of John’s financial success would have been possible without taking on debt.
Of course, his path could have taken a different trajectory. It’s possible John failed to lock down a tenant for several years and was eventually forced to sell in a down market.
In this alternative scenario, he may have been left financially worse off than where he started.
So, when contemplating using debt to build wealth, consider all the possibilities and, as always, do the math.
Finally, consider speaking with a financial consultant who can guide you down the best path for you, given your unique circumstances and personal goals.