What is the most important thing that distinguishes the wealthy from the common investor? In simplest terms it’s understanding how to make use of debt to buy assets and accumulate wealth.
The secret to accumulate wealth using debt efficiently is knowing the distinction between personal and corporate finance. In personal finance, most people use debt to acquire liabilities. In the field of corporate finance, companies borrow money to purchase cash flow-generating assets and make use of taxes (i.e. depreciation, for instance) to increase profits.
This article will help you discover how to distinguish between bad and good debt, look at examples of both, and find out how the wealthy use borrowing to make themselves better (mainly through leveraged buyouts).
Understanding Good and Bad Debt
Although debt is typically seen as a burden however, a lot of the richest people in the world use debt to increase their wealth. Good debt is borrowed to purchase a product which is anticipated to generate more money than the cost of servicing debt. This kind of borrowing can possibly lead to more income generation when compared to purchasing assets in cash (although there’s more risk). Bad debt, however, involves borrowing funds to buy items that don’t generate additional value or income for any period of time and, in addition, the interest needs to be repaid from different sources of revenue.
Examples of Good Debt
As previously mentioned the use of good debt is to purchase assets that produce income, and the price of borrowing is acceptable when compared to the expected returns. Good debt examples are:
- Mortgage Loans
It involves borrowing money to secure the home loans (for House Hacking) or purchase rental properties that’s income usually exceeds the mortgage and maintenance expenses. Additionally the tax benefits include deductions for loan interest or property-related expenses. The most important factor to be aware of is to stay clear of borrowing too much that could lead to difficulties in the repayment of loans.
- Business Loans
Entrepreneurs typically obtain loans with low interest for expansion plans for example, purchasing new equipment or acquiring a competitor.
With the help of taking out loans businesses can finance the expense of expanding without having to sacrifice ownership. This allows for greater flexibility than equity financing.
In the event that lenders require some type of collateral in order to obtain the loan, there’s always the possibility of loss of the collateral if you do not pay your loan on time. Before making any decisions about this type of finance, you should take a careful look at your business’s financial situation and be aware of the costs of capital in the present economic climate and determine if you’re able and willing to manage the debt with prudence and ensure it’s a successful loan.
- Student Loans
A majority of people think that investing money in education so long as it contributes to greater lifetime earnings and long-term results is a smart investment. This is why millions of people choose to take out student loans to fund their higher education.
But, they are among the few kinds of debt that can’t be discharged through bankruptcy. So, even if you are able to borrow a student loan for a significant amount at a rate that is favourable, there is a certain degree of risk associated with this kind of debt.
But, the majority of most successful people in the world are lifelong learners who constantly search for ways to expand their knowledge, whether it is through further degrees, certificate programs, mentoring and coaching courses, books or other classes.
Furthermore, certain education expenses can be tax-deductible.
Before you take out any amount of money to finance expenses related to education, be sure you know the terms for the loan. You are able to make the monthly payments, and that you are determined to achieve your financial goals, and learning the knowledge and skills that have the potential to enhance your earnings over time.
Examples of Bad Debt
Poor financial debt (AKA inefficient debt) which includes payday loans, car loans, credit cards and loans could be harmful to your financial goals since they do not generate any revenue. Let’s look at a few instances of bad debt.
- Credit Card Debt
Credit card debt in America stands at an all-time record high. According to the U.S. Census Bureau, each U.S. household has around $8000 of credit card debt, on average. Although some credit card companies offer attractively low promotional rates – in some instances, as low as 0 percentage interest for between 6 and 24 months – a lot of credit card companies have annual interest rates of more than 24.99 percent once the promotional period ends. Due to this, it is possible to find yourself in a situation where the cost of servicing your debt is greater than the amount of money you borrowed if you’re not cautious.
Additionally, as a word of caution If you’re a customer with an offer of 0%, it is still necessary to pay a minimum monthly amount. If you don’t pay, your credit card provider could take this as a “default” in payment and immediately increase your rate to the full rate of interest. It’s easy to imagine, the majority of people don’t realize that they have large amounts of balances on credit cards with 0% interest and end up in a loan with high interest even though they planned for a payback period of 6-24 months.
In certain instances business owners may benefit from these credit card offers with low interest rates to finance expansion of their business that is why it’s considered Good Credit. Many people however use credit cards to purchase things like clothes, electronics, holidays, and other items.
- Payday Loans
Payday loans are typically viewed as an extremely predatory type of finance designed to benefit people with lower incomes who aren’t able to access traditional credit options. One of the main issues with this kind of loan is the potential to entangle the borrower in a cycle of borrowing money to pay expenses, and then taking out more money to repay the lender.
- Car Loans
Car loans are a type of bad debt due to the average vehicle losing half its value within the initial five years. This means you may be liable for more on the car you own than your vehicle is worth. The majority of car loans come with interest rates which exceed those of other kinds of loans, like student loans or mortgages. That means you’ll be paying higher interest over the course of your loan. Additionally, car loans may make a substantial monthly charge in your financial budget. This could make it difficult to reduce your expenses or to pay off other loans.
How the Rich Use Debt to Get Richer
The rich have come up with a variety of strategies to make use of the power of debt to their advantage. In particular, since borrowed money is not considered income, it’s not taxed. Because of this, wealthy people often borrow money, then purchase the cash-flowing asset and then pay minimal to no tax on the money they earn through depreciation, as well as other deductions.
The Arbitrage Strategy
While the typical investor invests to secure Money Later (i.e. long term wealth and future cash flow), wealthy individuals, particularly Bankers focus on investing for Money Now (i.e. cash flow in the short term).
Wealthy people earn passive income from arbitrage through finding sources of income (such as companies, bonds, or real estate) in addition to borrowing funds against these assets to gain leverage to buy more assets. If properly harnessed this leverage allows the wealthy to gain more from their investment than they need to pay in interest charges on loans.
As an example, suppose an individual with wealth buys an investment property worth $1 million. Then, they take out a loan of $800,000 on the property at a 6% APR. If the property is able to generate $100,000 in annual rental an investor will be able to generate positive cash flow of $52,000 annually plus $800,000 worth of new investment capital.
In addition, because of the method of depreciation an investor in real estate can also take deductions up to 3.636% of the property’s worth every calendar year ($36,000 in this instance) and not have to pay taxes on that sum.
This is only one example of how wealthy people earn passive income by arbitrage. There are many different methods of doing it however, all arbitrage opportunities will require the following elements:
- An asset that earns money. This means that it needs to produce cash flow on a regular basis.
- A lender who is willing to credit against the asset to serve as collateral.
- Amount of income that is higher than loans’ payments and expenses.
The Buy, Borrow, Die Strategy
Another strategy used by the rich to boost their wealth and avoid taxation can be one called the Buy, Borrow, Die strategy. Here’s a quick overview:
First, you must “buy”. A family or a wealthy person acquires an asset that is likely to appreciate over a prolonged time. The second stage of the investment plan is “borrow”. Instead of selling the assets whenever they need cash (which will result in capital gains tax) they take out loans against them and use assets as collateral.
The final step comes with “die”. When the owner who initially owned the asset dies, it will be passed on to their successors or their beneficiaries. They can then trade the property (once they’ve paid off the loan balance of course) without paying capital gains tax and evade capital gains tax because of step-up base rules.
The Leveraged Buyout Strategy
Private equity (PE) firm is a type of financial institution that invests in private businesses that are undervalued, or have the potential for growth. They make use of a variety of investment strategies, however leveraged buyouts (LBOs) are the most popular type of investment made by PE companies.
Let’s see how PE firms use leveraged buyouts:
- Choose a business that they think could improve their operations in a significant way. This could mean cutting expenses, increasing revenues, or entering new markets.
- Borrow as much money as they can to finance the purchase of the company.
- Utilize the cash flow of the business to pay for the debt.
- Sell the business in the near future with the hope of making the company to make a profit.
The reason leveraged buyouts can yield above-market returns is due to the leverage. If you take out loans for investing, you will gain more from your investment as you’re not making a large investment of your own cash.
Contrary to the Buy, Borrow, Die strategy described in the earlier section, LBOs are more like Borrow, Buy, Sell. In some instances they can be Buy, Borrow, Plunder, Sell or even Bankrupt (whichever is the most profitable).
Are you looking to make better financial decisions similar to the ultra-rich? Meet with experts from Parr & Ibarra CPA today and learn about using the power of debt to help in creating real wealth.
