Warren Buffett said that people have the opportunity to become very rich using borrowed money to build wealth… or, very poor. So how can you use someone else’s money to increase your wealth?
There are a few ways that you can leverage debt to create wealth. It can be a risky strategy but understanding the financial markets and the current economic climate will help you to make informed decisions. Remember that this is a form of gambling and although using borrowed money to build wealth can give you big wins, it can end up doubling your losses.
Firstly, you need to understand debt isn’t always the villain it’s been made out to be. Good debt is a debt that is used to create income (such as buying a business) or as an investment into an appreciating asset. Creating good debt and using it to work for you is called ‘gearing’.
Mortgages
Home loans are a form of good debt. If you purchase a home, you are removing the need to pay rent and also investing in what is normally an appreciating asset. If your home loan of $500,000 has an interest rate of 5 % and you take 30 years to pay it off, then you’ll end up paying approximately$967,000 for your home – assuming the interest rate doesn’t change in that time (which of course it will).
If your home was worth $500,000 when you purchased it, after 30 years it is reasonable to assume it will be worth a lot more. House prices have risen 17% since 2012 in New Zealand. While this rapid house price inflation won’t continue (and house prices may even fall for a period of time ); even with a conservative estimate, it is likely the home will be worth well over a million dollars in 30 years.
This means that using the bank’s money to buy your home has resulted in a profit to you. This is an excellent investment strategy and a fairly reliable way to grow your wealth. If you buy investment properties, these can yield similar results if you are wise in which properties you buy and how you service your debt. If you spend that same $500,000 but then rent the home out for $500 a week, you’ll not only have a property worth more than a million, but you’ll be making $26,000 a year from rent payments (not accounting for expenses and taxes).
Another sneaky way to use the bank’s money to your benefit is to buy a section. You’ll need a smaller deposit than when buying a house. You can even use your KiwiSaver to buy the section. Then, start paying the section off. The land will appreciate over time. Get it re-valued, and using the higher valuation combined with the amount of the mortgage you’ve paid off, you can borrow more from your bank in order to build your home. Before you know it, you’ll have a house that you own with a significant chunk paid off- all without having to pull together a large deposit.
Borrowing to invest
If you can get a loan on a low interest rate or a mortgage extension, then consider buying shares with that money (sometimes called debt recycling). If these stocks and sharesappreciate in value, this can be a wise financial strategy. If your loan has a 5% interest rate and you are getting a return on investment of 10%, you’ll be making 5% profit on the transaction- more than interest from savings sitting in the bank, and all using someone else’s money!
$10,000 loan
5% interest charges = -$500
10% ROI = $1,000
Profit = $500
However, what happens if the stock loses money? Suddenly your investment is worth less than before.
$10,000 loan
5% interest charges-$500
10% loss on investment = -$1,000
Loss of investment and interest paid = $1,500
This kind of debt is only as good as the investment. If you’re making more money than you’re losing, it’s an excellent way to put someone else’s money to work for you.
Should you pay off debt or save money?
When people create a budget and start looking at their finances, they start to wonder: should they be saving money, or paying off debt? What is good debt management and how can you make this work for you? In some instances, it’s far better to save than pay off debt; namely, when the money you make from the savings is more than the interest you’ll pay. For instance if you buy something on hire purchase with a twelve month interest free term, you can save the money instead of paying the hire purchase. When you have enough saved (before the twelve month mark), pay off the purchase before it starts incurring interest. It might not make you thousands of dollars, but that money is better off in your bank than in a retailers.
Start a business
A loan used to start a business is an excellent way to create wealth. As the loan is for an appreciating asset, it’s another form of good debt You could also enlist an angel investor who gives you money, often for an agreed percentage share of profits. This is a great way to start a business that might require capital investment to get it kicked off.
When to avoid using debt to grow wealth
All the strategies mentioned above are based on speculation – nothing is guaranteed – and as such are a form of gambling. Do not gamble what you can’t afford to lose. This applies particularly to people closer to retirement. Avoid borrowing and creating debt and don’t risk your retirement savings on financial guessing.
Who should use debt to create wealth?
If you can put aside preconceived ideas of all debt being bad, and are comfortable taking measured risks, then creating wealth using someone else’s money is a very real possibility.. However, you need to be careful about the risks you take – you don’t want to end up creating more debt. If you are unsure how best to proceed, or need advice about what you should invest in, then talk to a financial adviser for professional assistance.
Disclaimer: All the figures in this article are for demonstration purposes only and are not intended or implied to be a substitute for professional financial advice. Accordingly, Enlightened Life Limited accepts no responsibility for any loss caused as a result of any person relying on the information supplied.