How To Use Debt To Create Wealth
How to Use Debt to Create Wealth
Much like ‘ego’, the word debt is often considered negative. But not all debt is created equal. In fact, if you’re careful and think about it strategically, you can actually use debt to create wealth.
Let’s take a look at what ‘good’ debt is, and how you can deploy it in your overall financial strategy to create wealth.
Good Debt/Bad Debt
Some people use the terms good and bad, others efficient and inefficient. But essentially there are two kinds of debt:
- Good/Efficient – this term describes debt that is used to acquire appreciating assets that help create income or capital growth to build long-term wealth. It incorporates things like mortgages on properties, loans to by shares, and student loans which might improve employment and salary prospects.
- Bad/Inefficient – this type of debt is generally high-interest and is used to fund ongoing living expenses, and to purchase items that don’t appreciate in value. Personal loans, car loans and credit cards are examples of bad or inefficient debt.
Cost & Risk
Another way to look at debt is to assess the cost and the risk. Of course, all debt comes with some level of both. However, good/efficient debt tends to be lower cost and generally lower risk, primarily because you have an asset to balance against it, and sometimes to create income from which to service the debt.
Bad or inefficient debt can negatively impact your cash flow and credit rating, and should your circumstances change, you have no asset or income to balance against the debt.
Whatever level of debt you are considering, you need to look carefully at what level of risk you are prepared to bear, and whether the underlying asset you are considering funding fits your risk profile.
If you haven’t looked at your risk profile recently, doing so before you commit to any debt, even if it is good/efficient debt, is essential.
The First Step
Before you set about taking on wealth-creating good debt, it can be a worthwhile exercise to eliminate, or at least minimise, any existing inefficient/bad debts.
Since inefficient debt generally comes with a high interest rate, the faster you can pay it off the better. If you have a high level of this kind of debt, sometimes it can be a good idea to roll it into a lower interest rate product, like your mortgage.
However, if you do this it’s important not to run those inefficient debt levels up again. Keep them under control and pay them off monthly so you don’t end up back where you started, depleting your income with high interest payments.
Investing In Debt
So, how do you actually use debt to create wealth? There are a few methods you can utilise, depending on your personal circumstances, risk profile, and preferences.
This is where you use money borrowed at a lower interest rate to invest in a higher return product. For instance, if you can borrow money at 5%, but the return on the proposed investment is 10%, you have leveraged that loan to make a 5% profit.
Borrowing money for leveraging allows you to invest more money than you have available, while at the same time potentially retaining cash reserves for emergencies. This means there is less likelihood you will have to sell investments at the wrong time, which can lead to a negative impact on your position.
This is where you use lump sum windfalls, like bonuses or tax returns to pay down inefficient debt. You then borrow the same amount via a more efficient debt to invest in an income-generating or capital growth products, like real estate, shares or managed funds.
Using this strategy, your overall debt position doesn’t change, but you now have income or capital growth, which you can use to re-invest, as well as lower interest payments.
This allows you to buy more stock than you have funds available for, and involves your broker lending you money to buy additional shares. For example, if you have $100,000 in your broking account, but you want to invest $150,000 in a particular stock, your broker can provide the additional funds.
If the stock appreciates, you pay back the loan and take the profits. However, if the stock depreciates, and the value of your holdings drop below an agreed amount, your broker will issue a ‘margin call’, which is a requirement to pay the money back.
If you can’t meet this margin call your broker can choose to liquidate your account, leading to potentially big losses. Margin investing is a high-risk high-reward strategy and not for the faint of heart.
This is a process whereby you borrow stocks from a broker-dealer, and then sell them on the open market, with a plan to buy them back if or when the price of the stock drops. The difference between the price you sold at and the price you bought at is your profit. Of course, if the stock rises, the reverse is the case, and you can find yourself with a shortfall in funds that you will need to pay back.
Short selling relies very much on being engaged with the market, understanding where stocks are likely to go and being able to time the top and bottom of their movement. Not to mention nerves of steel!
As we said earlier, incorporating any kind of debt into your financial plan comes with a level of risk. Getting informed and balanced advice is essential in protecting your finances and ensuring taking on a debt doesn’t reverse the forward movement of your wealth creation plans. It’s important to work with an experienced financial planner who has a good understanding of when and how to use debt effectively.
If you would like to incorporate debt strategies into your financial plan, and are not sure where to start, or would like to recalibrate your financial plan to make better use of debt opportunities, Manly Financial Services can provide the advice and expertise you need. We’d love to chat, so give us a call on (02) 9976 3388, or contact us via the below link.