The word “debt” sounds scary and intimidating and carries a negative connotation to many. In today’s culture, we are endlessly bombarded by people telling you how bad debt is, and to stay away from debt at all costs. While this is true in some cases, if used properly, it can also be a positive.
Many companies these days tend to carry a lot of debt on their balance sheet. There are number of strategic reasons for doing so but the primary purpose is to finance parts of their business (acquisitions, inventory, etc.) to accelerate growth and ultimately future profitability. There are two primary benefits to this. First, companies can deduct the interest on the debt from their corporate income taxes, which brings their cost of debt down significantly. In addition, using debt is cheaper than financing using equity. If the company is run well and has positive future growth prospects, using debt could be extremely valuable.
You might be thinking to yourself, “Well, I am a person (not a company) so what does this have to do with me?” The short answer is many of the same principles listed above can be applied towards individuals. Although many forms of debt cannot be classified as being good, there are circumstances in which taking on debt can be beneficial if it allows you to make a purchase that will pay off in the long-term. This pay-off can either increase your net worth or increase your income.
Mortgage Debt
One example of this type of debt is a mortgage loan. Many do not have enough money saved to buy a house outright. This is where a mortgage loan comes into play. Residential properties have historically increased in value which will increase your net worth. Many people today are using debt to finance rental properties as a means of generating passive income and to improve their net worth. Depending on rental rates as well as their cost of capital (interest rate) the rental payments received can sometimes cover or exceed the total cost of mortgage and taxes, which creates an income stream for the investor while someone else is paying off their appreciating asset. There are obvious risks associated with this strategy, mainly, the house needs to be occupied and the tenant needs to pay the rent. However, becoming a landlord and investing in real estate can be a very lucrative strategy with tremendous long-term benefits.
Student Loan Debt
Another example of this type of debt is a student loan. There are many horror stories about the dangers of these types of loans, but a college degree can create opportunities for many. It would be great to graduate college without any debt, but this can be a difficult option for some. This is why student loan debt can be a debt worth taking on – it is debt that will ultimately pay for itself and help you make more money in the future.
Starting A Business
Another example of debt that could help you is borrowing money to purchase or start a business. If this business provides a worthwhile product and is managed well, the company should generate a profit and could become a good investment. The main thing to remember is that with all three of these debts (mortgage, student loan and business) you are acquiring debt to enable you to earn more money and/or increase your net worth.
Margin Investing
Margin investing is a term that refers to the concept of borrowing stock for a value above what an investor has money for with the hopes of stock appreciation. A margin account allows you to put up a maximum of 50% of the purchase price of a stock. For example, if you have $100K in cash, an additional $50,000 would be loaned to you by the brokerage at a specified interest rate. Your $100,000 investment gives you $150,000 worth of buying power which you could use to buy $150,000 worth of stock.
If the stock price appreciates, then you can pay back the loan and pocket the profit. The downside? You have probably heard the term “margin call” before. What that means is if the value of the investment in your account falls below a certain value, your brokerage firm can issue a margin call. If you can’t meet your margin call because you don’t have sufficient funds, your broker can liquidate your entire position in a stock leaving you with losses
Some Pointers
There is a simple rule of thumb regarding debt, and that is if taking on debt increases your net worth or has future value, it is good debt. If you are not using it to buy an appreciating asset, but rather to buy depreciating assets or anything disposable because you don’t have cash to pay for it, that would be considered bad debt. If you borrow money to purchase something, the following criteria should be met:
1. The item should be something that will increase in value or produce an income.
2. The value of the item should be equal to or worth more than the amount borrowed to purchase the item.
3. The amount borrowed should be within your ability to repay without placing a strain on your budget.
4. If you are using debt to purchase an asset (real estate, margin investing, etc.) you need to feel comfortable and confident that the returns you will generate from the investment will exceed your cost of borrowing (interest rate).
What’s The Verdict?
There are many cringeworthy stories of individuals who had no business taking on debt. However, if your financial house is in order, debt can be used as a tool to generate even more wealth.
It may go against conventional wisdom because debt is seen as a downward pull on an individual’s finances, but if used correctly and managed appropriately, debt can allow individuals to make purchases they wouldn’t otherwise be able to, thus, enhancing their returns significantly.
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