Borrowing to Invest: Helpful or Hurtful?
Philip's recent article entitled Good Debt Bad Debt sparked quite a debate as to whether any debt can be considered good debt.
And as far as being in debt for luxury items or non-essentials goes, I agree that carrying debt is a bad habit to get into. Interest dollars paid each month are going down the drain to help you pay for items that in many cases have already been consumed.
But to carry debt that enables you to earn money is a concept called Leveraging, and can be very effective in building wealth, businesses, and incomes.
Mechanically speaking, leveraging is the act of using a lever to gain a mechanical advantage or additional power.
Financially speaking, leveraging is similar. Dictionary.com defines it as:
The use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one's investment, to control a much larger investment, or to reduce one's own liability for any loss.
There are a number of ways to leverage your money, some of which you may already utilize:
This is the most common form of leverage, however it isn't truly a leverage in the same way since you aren't borrowing to earn an income. But in its most basic form you are leveraging your way into your new home with the use of a mortgage.
For simplicity's sake, I'll illustrate the effectiveness of leveraging into home ownership with round numbers. You put $10,000 down on a $100,000 house. This house appreciates in value 2% over the next year. If you were to sell the house after a year, you would walk away with $102,000 (commissions and other erroneous expenses aside). Thus, in one year, you made $2,000 on your initial investment of $10,000. So although the house itself increased in value only 2%, your personal return on investment (ROI) was 20%.
This is a case often used in favour of buying a home as opposed to renting. Not only are you building equity as you pay off your mortgage, but you own and are reaping the benefits of an appreciating asset that would normally be beyond your reach to own outright.
The Down Side: If your home depreciates in value beyond the equity you have managed to accumulate, you could end up in a pickle. I have a friend who purchased a home for $200,000 with $10,000 down, got divorced two years later and had to sell the house. Unfortunately during that time the housing market crashed, and he could only sell the place for $170,000. So taking into consideration his down payment plus equity accumulated in the two years, and subtracting sales commissions eating into his proceeds, he sold the house with nothing to show for it but $25,000 in debt.
If you have dreams of being in business (especially one that involves a storefront of sorts), you usually have to come to grips with the idea of being in debt. To purchase a franchise can cost anywhere from $20,000 to $2,000,000 just to get started. And walking into the franchise office with $2 million in cash is a rare occurrence, indeed.
However business debt is also good debt, as it is a truer form of leverage. You are engaging in the act of borrowing money with the expectation of earning an income, which makes the interest on that loan tax-deductible.
You are also making a down payment on an asset that not only provides you with an income, but also might appreciate capitally.
Similar to above, you invest $10,000 down on a $100,000 business. (This is a very simple example, of course). The business kicks off an income of $10,000/year. You can use this income to help make loan payments, which is a great way of making the debt pay for itself. But depending on the business, you may also find that there is a capital appreciation. For example as you build up a loyal customer base and good reputation, or if you own the underlying property, you may well be able to sell the business for more than the $100,000 you bought it for. This gain on the overall amount can again be expressed as a larger return on your investment of the initial $10,000 plus loan payments.
The Down Side: As with home ownership, if the business goes belly-up and there's nothing to sell, bankruptcy could very well be imminent. This is the inherent risk of owning a business, especially one that requires a capital outlay to get started. There are many tales of business owners losing everything they have, but also just as many about business owners who are earning incomes, plugging away at their loans, building equity in the business, and creating a retirement nest egg in addition to fulfilling a dream. And even a few tales of wild riches achieved with good business investments. Nothing wagered, nothing gained.
Although investments don't produce an income in the conventional "salaried" sense, many can indeed be income-producing for the purposes of leveraging. And again since you are borrowing money with the intention of earning an income (whether or not you actually do earn income, at least initially), the interest on the loan is tax-deductible.
The appeal behind investment leveraging is best when the interest rates for borrowing are low. For example, you borrow $100,000 with $10,000 down at 4% interest, and turn around to invest that $100,000. The 4% interest is a tax deduction, which means your net interest expense out of pocket is closer to 3%. Your investment then needs to make more than 3%/year in order for the leveraged loan to work out.
If your investment makes 8% or $8,000, and you subtract the $3,000 in net interest expenses, your gain is $5,000. If you express the $5,000 as a return on your investment of $10,000, you just made a 50% return!
The Down Side: Although the gains are magnified with investment leveraging, so too are the losses. If your investment loses 8%, then your net return on investment (taking into account interest paid) is over a loss of over 100%! However investments tend to trend upwards given a long enough time frame (8-10 years at least), so even initial dips in the market can be recouped significantly and the leverage strategy can work. But a long time frame and investment perspective are very necessary ingredients for this recipe to work.
Real Estate Investments
The concept of leveraging into real estate investments is a combination of the Business and Home Ownership strategies of leverage. Similar to the Business strategy, you are borrowing money with the intention of making an income (being rental income). So again the loan interest is tax-deductible. And with the real estate ownership, you are also banking on the appreciation of the asset in question to increase your return on investment.
The Down Side: If you can't find tenants to help you pay the mortgage, then you'll have to come up with the cash somehow yourself. If your resources are tight that might be a stretch. Real Estate market losses are also a risk when it's time to sell.
Risks and Notes to Potential Leverage Candidates:
- Have extra cash on hand. This is good for covering loan payments when expected income isn't forthcoming.
- Make it a long term investment. Since both gains and losses are magnified when leveraging, you need to allow a proper time frame for the asset to appreciate and recover from bumps and corrections in the market.
- Do your due diligence. Meet with your financial planner, real estate agent, or business mentor. Ask people who have leveraged how it has worked for them. You'll find both tales of woe as well as tales of abundance.
- Go with your gut. Leveraging is risky, no doubt about it. If you are the sort to wake up in the middle of the night in a cold sweat because you're worried about your debt, then you are not a good leverage candidate. You may miss out on some superb returns, but at least you will have your health and a stress-free investment plan.