Leverage: Is Debt Good or Bad; How can you use Debt to Make you Money?(Part1)

 

Debt, a good number of people fear it, despise it and run from it. The dream financial position for some people to be in is "debt-free". But is being debt-free always the best position to be in? Are there some benefits to having debt? Some others are "perpetual debtors", the term "drowning in debt" comes to mind; always in some form of debt and they can't ever seem to find their way out. Is this lifestyle inherently wrong? Have they made poor life choices?

The first thing you must recognize is debt or credit on its own is neither bad nor good; it is what you do with debt that makes it so. Good debt is simply when you borrow to buy an asset that pays more than enough to cover the interest from your debt. An asset is something that can bring you more money either now or in the future. Your car/laptop is an asset if you use it for business purposes to earn more money. Your mind is an asset if you can use your ideas and thoughts to add value that makes money. To a model, their image and likeness are assets.

Bad debt is when you borrow for that which cannot generate future profit. When you borrow to invest AND the profit you make from investing is more than the cost of repaying your debt, then that's good debt.

 

For example: If you take a loan of 100k from a bank/friend at 5% annual interest to invest in your business/another investment like real estate or agricultural projects etc. & your business/investment yields 10% profit annually, that's good debt. Why? Because you pay 5,000 in interest on your loan while your investment is paying you 10,000. That gives you a profit of 5,000. BUT if you borrow for something that either doesn't make you any money at all like a wedding or to buy a brand new car for personal use, that might very much be a bad debt. Not because those things are inherently bad, but if you use debt to buy something that is not going to pay you more money in the future, then that is bad debt.

You can also think of it in the long term. If you take student loans to study a course that can make you more money in 10-30 years, then that can be good debt, but if you borrow for a course that has very little market value, that could be bad debt. It may also not be so clean cut. If borrowing to buy a brand new Lamborghini for personal use or to buy a house in the high brow part of your city as a person that sells luxury goods helps you appeal to wealthier clients and sell more goods, then that could also be good debt. 

The logic is simple: if you borrow to get something that will NOT give you greater monetary value (more money) in either the short or long term, that is bad debt. While if the value you get from borrowing is more than what you have to pay back, then that can be good debt.

How can you use debt to build wealth?

The popular phrase "you need money to make money" comes into play here. If you could invest in something that guarantees 10% returns irrespective of how much you invest, and you could either invest 100,000 or 100 million, which would you prefer? Obviously 100 million, why? Because 100 million could make you 10 million in profit while 100k would only make you 10k in profit. The more money you have at your disposal, the more money you can make. When you need money for personal use, the options available to you are typically to draw from savings or investments or borrow. The savings/investments you have are very limited to what you earn as such if you want more money to invest, you need to borrow. Back to our scenario, if you have 50 million of the 100 million you would like to invest, and you can borrow the remaining 50 million at a 7.5% interest rate, should you borrow or should you invest the 50 million you have?

Let's look at the math; if you invest your 50 million, you will get 5 million in profit which is 55 million in total. While if you borrow the extra 50 million, you would have 110 million in total after the investment pays out. Remember you have to pay back the loan, so you pay back 50 million, which is the amount you borrowed and 3.75 million, which is the 7.5% interest on the loan. This leaves you with 56.25 million, which is more than the 55 million you would have had if you invested just your money.

For a business, it gets more interesting. Publicly listed companies can get money from their profits, from issuing shares to the public and borrowing. However, there is a limit to the amount of profit they have so if they need more money than their profits can cover, they might have to look elsewhere. The next option would be to issue more shares. But this option would mean that they would have more owners (dilute ownership or "more cooks in the kitchen") and some companies may not want this because as they get more shareholders, it could make it more difficult to arrive at decisions. It could also affect the quality of decisions that they make. Also, there are other costs with issuing shares such as paying for underwriters etc. and issuing more shares could affect the share price of the company because again remember the principle of demand and supply, if the company issues shares and there are not enough buyers looking to buy, this might cause the price of the company shares to fall, and they might not be able to raise the exact amount that they need. So, the next best option is to borrow.

If a company can borrow at an interest rate that is lower than the profits they expect to get in the short/long term, then debt would be a great option because they could increase their profits and "return on equity" which would be good for their share price. Remember, return on equity is net profit divided by shareholder's equity. If the net profit increases and shareholder's equity remains the same, then return on equity would increase.

In summary, the benefit of debt is you can use someone else's money to increase the size of your business and increase your profits while paying them interest.

Credit @Oghenerukevwe Odjiugo(linkedin.com/in/oghenerukevwe-odjugo-9716a9140

 

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