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Why You Need More Debt in Your Life

Finance

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3.2.21 |

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How to use debt to create wealth

Alright, let's talk about the big scary "D" word — debt.

In the world of finance, there’s good debt and bad debt.

Bad debt is often what comes to mind when many of us hear the word “debt”. Bad debt involves borrowing money against assets that depreciate over time, or even one-off experiences, leading to fixed payments and a decrease in overall value. Good debt is often overlooked. Good debt is borrowed money that is used to purchase assets which have the potential to appreciate or generate positive cash flow, or both, surpassing the debt payments and associated expenses.

Using someone else's money to grow your wealth doesn’t have to sound like playing high-stakes poker. Let’s explore the difference between good debt and bad debt, and how you could use debt to create cash flow and capital gains.

Debunking Debt Myths: Friend or Foe?

First things first, let's bust some myths surrounding debt.

We've been told time and again that debt is the enemy, often viewed as something to be avoided at all costs.

However, not all debt is created equal.

Good Debt vs. Bad Debt: The Showdown

Good debt is like your trusty sidekick, helping you achieve your financial goals and build wealth. Think mortgages, business loans, or student loans — investments in your future that can yield long-term benefits.

On the flip side, bad debt is the villain of the story — credit card debt, buy-now-pay-later (BNLP), high-interest loans, and impulse purchases on credit that drain your bank account faster than you can say "financial disaster."

Famous billionaire investor Warren Buffett is wary of credit cards and warns against getting one.

“Interest rates are very high on credit cards,” Buffett said. “Sometimes they are 18%. Sometimes they are 20%. If I borrowed money at 18% or 20%, I’d be broke.”

Grant Cardone, a private equity fund manager and real estate investor, agrees, saying “the fastest way to go broke is to use debt to buy junk”.

But he says not all debt is created equal, and debt “is not evil”.

“I get asked constantly, ‘Grant, what should I have debt for? When's good debt good? When's bad debt bad?’ I'm going to tell you that debt is absolutely necessary in order for you to create wealth. If you want true wealth, prosperity, and affluence in your life, you must use debt to get there.

“I know there's a lot of people out there that will challenge this,” he added.

Personal finance expert Dave Ramsey would be one of them. Ramsey is well-known for taking a conservative approach to money and for avoiding debt at all costs.

“My boy Dave Ramsey wants to tell you to never go into debt, but the wealthy get rich with debt,” says Cardone.

Cardone says Ramsey’s advice is perfect for those struggling with consumer debt, the kind of “debt that will take you to zero”. For example, borrowing money to buy a car, expensive clothing, or furniture.

“They borrow money for Gucci belts and try to pretend to be somebody they’re not,” he explained.

“I'm not talking about consumer debt. I'm talking about business debt. I'm talking about turning fiat [currency] into real property.”

Cardone says the key is to leverage the money you borrow.

“Debt that is paid off by others or debt that actually generates income is good debt; assume all other debt to be bad,” Cardone added.

“Rich people use debt to leverage investments and grow cash flows. Poor people use debt to buy things that make rich people richer.”

Cardone says real estate is a good example of good debt.

“It has the potential to generate both capital appreciation and cash flow,” Cardone noted.

Five Questions to Ask Yourself Before You Borrow

Cardone says there are five questions to ask yourself if you want to make your debt work for you, instead of against you.

When you are looking at taking out debt, ask yourself these questions:

Does it create wealth? Does it have any chance to create wealth?
Does it provide leverage?
Is it deductible?
Does it provide cash flow?
Can I depreciate the assets that I'm purchasing?

Real Estate and Leverage

Ever wondered why the wealthy seem to have a knack for accumulating assets and multiplying their wealth?

It's because they understand the power of leveraging debt to fuel their investments.

Take real estate, for example — it can be a goldmine for savvy investors looking to grow their cash flow and expand their portfolio.

Instead of using $100,000 in savings to buy depreciating assets like fancy cars, Cardone suggests leveraging it to purchase real estate.

Leverage to Multiply Asset Value

Leverage in real estate refers to the practice of using borrowed funds (usually a mortgage) to finance the purchase of property. Most often this is residential property in the form of houses, townhouses, or even apartments. This approach allows investors to control a larger asset value with a smaller amount of their own capital.

If you purchase a property worth $1 million with a down payment of $200,000 by borrowing the remaining $800,000 from a bank, then you are leveraging their investment. You are controlling an asset worth more than your own personal investment.

In this case, if the value of the property goes up to $1,200,000 you haven’t made a 20% return, you have made a 100% return. That is, you have doubled the value of the $200,000 you invested. This is the true power of leverage.

One of the biggest advantages of real estate (property) investing is its reasonably straightforward for most people to obtain debt on the real estate asset in the form of a mortgage. This means you can acquire more assets with less money upfront, amplifying your returns in the long run.

Leverage amplifies both potential gains and losses in real estate investments. While it can increase returns if property values rise, it also increases risks if property values decline, as the investor is still responsible for repaying the borrowed funds. Therefore, leveraging in real estate requires careful consideration and risk management.

Leverage can also help you spread your capital across multiple investments at once. Property equity is the gap between the value of your home and the remaining mortgage balance. As you pay down your mortgage principal, your equity grows. Leveraging equity for buying more property entails accessing the capital or equity in your home with approval from a bank or lending institution, which can then serve as a deposit for the next property purchase.

Robert Kiyosaki, the author of the cult-favourite 'Rich Dad Poor Dad', says he owns 12,000 properties.

“I own about 12,000 rental units, but the real story is how did I acquire those properties? I use debt,” he said in an interview with Vlad posted on YouTube.

Kiyosaki says he leveraged debt to buy more properties and subsequently reduced his tax liability. He says he paid for his luxury vehicles as they are examples of liabilities, not assets.

Debt Risks

There are risks when it comes to using good debt, so we’re not at all suggesting everyone go and borrow every cent they can access.

Negative equity is one outcome that can arise, especially when borrowing to invest in real estate. Some buyers who purchased at the peak of the market in 2021, for example, found themselves in a situation of negative equity following the market correction.

Negative equity occurs when the current market value of the property is lower than the outstanding balance on the mortgage or loan secured against it.

Kelvin Davidson, CoreLogic’s chief property economist, noted that among the approximately 500 sales resulting in losses during the quarter, around 100 were individuals who initially purchased their properties as first-home buyers. Among this group, roughly 50 had made their purchases within the last two years.

Leveraging to access a greater return should only occur after careful and thorough analysis of the benefits and risks, weighed up against what the investor is aiming to achieve.

Important Considerations:

Risk: Leverage magnifies both gains and losses.
Interest Rates: The cost of borrowing money (interest) will eat into your profits.
Cash Flow: You’ll need the cash flow to make loan interest and principal repayments.

Debt and Stocks

Some investors decide to borrow money to invest in the stock market.

Buffett has previously spoken against using debt and leverage to buy stocks.

In a “Squawk Box” interview, Buffett shared the view of his business partner Charlie Munger.

“My partner Charlie says there are only three ways a smart person can go broke: liquor, ladies and leverage,” he said. “Now the truth is — the first two he just added because they started with L — it’s leverage.”

He previously said he believes it’s “crazy” “to borrow money on securities”.

“It’s insane to risk what you have and need for something you don’t really need. ... You will not be way happier if you double your net worth.”

He says leveraged investing can make an investor short-sighted and panicky when times are rocky.

“There is simply no telling how far stocks can fall in a short period,” he wrote in his 2017 annual letter to shareholders.

“Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”

Leveraged investing of any kind carries significant risks and requires strong cash flow, discipline, risk tolerance, and a deep understanding of investment principles to mitigate potential losses.

Ultimately, individuals considering leveraged investing should conduct thorough research and assess their financial situation before diving in.

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A point to note about Buffett’s approach, nearly all the companies he invests into have debt themselves. That is, those companies are borrowing to invest in their own growth.

Business Loans

Businesses also utilise leverage, borrowing money to fund capital expenditure, research and development, to fund short-term operations, and to fund acquisitions.

Copy the Greats

Most successful companies worldwide have utilised leverage to scale up their operations and achieve their current level of success.

The largest listed company in the world, Microsoft, has plenty of debt, but even more cash, and has paid a dividend (slice of profits) to shareholders for the last 20 years. Why borrow if they have cash in the bank?

Apple is the same, despite being one of the most valuable and most profitable companies globally, Apple still carries significant debt on its balance sheet. This might seem counterintuitive at first glance, but there are reasons behind it including their ability to lock in low interest rates, tax strategy, investments and acquisitions, and shareholder returns.

At the other end of the scale, during the initial phases of establishing and operating a business, entrepreneurs often opt for business loans to acquire essential capital. This isn’t always easy to obtain as most banks or reputable lenders won’t want to lend money to a business that isn’t making money yet!

An example of this might be financing a new piece of machinery to optimise productivity. Or perhaps it is a loan for a vehicle and tools to take on a new staff member, which will then increase the earning potential of the business.

While the lender may hold the rights to the interest payments and repayment of the debt, the business owner retains ownership of the business itself, along with the potential value of future profits and cash flow.

Just like for any individual, debt and liabilities pose risks to a business when it struggles to meet these obligations either through available cash flow or by raising capital affordably.

As always, careful analysis is key to ensure the return is worth the risk.

The Bottom Line: Do You Need More Debt?

While debt may seem daunting, it's important to recognise its potential as a tool for wealth creation when used wisely.

By understanding the difference between good debt and bad debt, leveraging opportunities in real estate and business, and carefully managing risks, you can harness the power of debt to fuel your financial growth.

So, embrace debt, but carefully. Remember, in the world of finance, fortune favours the bold — but it also favours the informed and strategic.