Most people say debt is bad
But you can use debt to build wealth
Here is how:
But you can use debt to build wealth
Here is how:
1/ Good Debt vs. Bad Debt
Debt can be “Good” or “Bad” depending on what it’s used for
“Good” debt is used to buy assets that appreciate in value
“Bad” debt is used to buy goods that depreciate in value
Debt can be “Good” or “Bad” depending on what it’s used for
“Good” debt is used to buy assets that appreciate in value
“Bad” debt is used to buy goods that depreciate in value
Examples of good debt:
• Debt used to buy a house/real-estate
• Debt used to buy a company
Examples of bad debt
• Debt used to go on a shopping spree
• Credit card debt
• Debt used to buy a house/real-estate
• Debt used to buy a company
Examples of bad debt
• Debt used to go on a shopping spree
• Credit card debt
2/ Buying an Asset You can’t afford
When you have to buy an asset you can’t afford, you use debt to help with the transaction
Let’s look at a typical example:
When you have to buy an asset you can’t afford, you use debt to help with the transaction
Let’s look at a typical example:
You’d like to buy a house worth $100,000 but you only have $20,000
So you put a down payment of $20,000 and get a mortgage of $80,000 to get the entire $100,000
So you put a down payment of $20,000 and get a mortgage of $80,000 to get the entire $100,000
3/ Leverage and Returns
You may have heard during the great financial crisis that banks used “leverage”
You might be wondering, what the heck that means
You may have heard during the great financial crisis that banks used “leverage”
You might be wondering, what the heck that means
At its core leverage, means “borrowing” and the concept is simple
Let’s take a look at an example of buying a house under 2 scenarios
Let’s take a look at an example of buying a house under 2 scenarios
Scenario 1
You’d like to buy a house worth $100,000 and you have $100,000
At the of the year, the house is worth $120,000.
You decide to sell
How much money did you make?
You’d like to buy a house worth $100,000 and you have $100,000
At the of the year, the house is worth $120,000.
You decide to sell
How much money did you make?
• Selling price $120,000
• Purchase Price $100,000
• Increase in value $20,000
• Your investment $100,000
You made $20,000 on your investment of $100,000
Your Return was: $20,000 / $100,000 = 20%
• Purchase Price $100,000
• Increase in value $20,000
• Your investment $100,000
You made $20,000 on your investment of $100,000
Your Return was: $20,000 / $100,000 = 20%
Scenario 2
You’d like to buy a house worth $100,000 and but you only have $20,000
So you buy the house by putting a down payment of $20,000 and borrowing $80,000 from the bank
At the of the year, the house is worth $120,000. You decide to sell
How much money did you make?
You’d like to buy a house worth $100,000 and but you only have $20,000
So you buy the house by putting a down payment of $20,000 and borrowing $80,000 from the bank
At the of the year, the house is worth $120,000. You decide to sell
How much money did you make?
• Sale price $120,000
• Purchase Price $100,000
• Increase in value $20,000
• Your investment $20,000
You made $20,000 on your investment of $20,000
Your Return was: $20,000 / $20,000 = 100%
• Purchase Price $100,000
• Increase in value $20,000
• Your investment $20,000
You made $20,000 on your investment of $20,000
Your Return was: $20,000 / $20,000 = 100%
Notice how your return in Scenario 2 is much better than Scenario 1?
That’s because of LEVERAGE
That’s because of LEVERAGE
Here is the KEY:
Leverage allows you to buy an asset you can’t afford and when the price goes up, you keep ALL OF THE GAIN
Leverage allows you to buy an asset you can’t afford and when the price goes up, you keep ALL OF THE GAIN
The increase in value in Scenario 1 and Scenario 2 are the EXACT same
But the rate of return on your investment is much better in Scenario 2 why?
But the rate of return on your investment is much better in Scenario 2 why?
Because you invested much less in Scenario 2
In Scenario 1 to get a return of $20,000 you had to invest $100,000
In Scenario 2 to get a return of $20,000 you had to invest $20,000
In Scenario 1 to get a return of $20,000 you had to invest $100,000
In Scenario 2 to get a return of $20,000 you had to invest $20,000
4/ Leverage in investing
In the investment industry, the concept of leverage works exactly the same way as the house purchase example in Scenario 2
In the investment industry, the concept of leverage works exactly the same way as the house purchase example in Scenario 2
Leverage is used to buy different assets such as:
• Stocks
• Companies
• Real estate
Investors in every asset class try to improve their rates of return by adding leverage
• Stocks
• Companies
• Real estate
Investors in every asset class try to improve their rates of return by adding leverage
5/ Using OPM to get Wealthy
There is a saying in the finance world, that:
Finance professionals use OPM (Other People’s Money) to get wealthy
There is a saying in the finance world, that:
Finance professionals use OPM (Other People’s Money) to get wealthy
Debt is the equivalent of using OPM to get wealthy
In Scenario 2, you couldn’t afford to buy the house on your own
In Scenario 2, you couldn’t afford to buy the house on your own
So you decide to get a mortgage from a bank - the equivalent of OPM to buy the house
Once the house appreciates in value, you repay the mortgage but keep ALL THE UPSIDE
Once the house appreciates in value, you repay the mortgage but keep ALL THE UPSIDE
6/ Other advantages of using debt
Another advantage of using debt is that it is a source of non-dilutive financing
What does this mean?
Another advantage of using debt is that it is a source of non-dilutive financing
What does this mean?
Non-dilutive means that you don’t have to sell equity (ownership) in your company to get money
When founders are looking for money for their business, the typical solution is to raise money from investors
When founders are looking for money for their business, the typical solution is to raise money from investors
This requires you to sell a portion of the equity (ownership) in your business
This is sometimes NOT a wise decision
This is sometimes NOT a wise decision
If you’re going to sell equity to an investor that won’t help you in your business,
Is this really the kind of exchange you want to make?
Why not get a loan instead?
Use the cash from the loan for your business, and KEEP OWNERSHIP of your company!
Is this really the kind of exchange you want to make?
Why not get a loan instead?
Use the cash from the loan for your business, and KEEP OWNERSHIP of your company!
5/ Rate of Return Arbitrage
If you got a bonus of $20k - should you pay off your mortgage?Â
If your mortgage has a low-interest rate like 2% but you can invest that $20,000 and make 7%,
If you got a bonus of $20k - should you pay off your mortgage?Â
If your mortgage has a low-interest rate like 2% but you can invest that $20,000 and make 7%,
It’s a no brainer, don’t pay the mortgage and make your dollars go further by earning that higher rate of return
Paying the mortgage saves you 2% of interest or $400 ($20,000 * 2%)
Making the investment allows you to earn a 7% return or $1,400 ($20,000 * 7%)
Would you rather save $400 or earn $1,400?
Making the investment allows you to earn a 7% return or $1,400 ($20,000 * 7%)
Would you rather save $400 or earn $1,400?
The answer is simple:Â
If you can earn a return that is better than the interest rate you have to pay on your debt,
Seize the opportunity to get a higher rate of return
If you can earn a return that is better than the interest rate you have to pay on your debt,
Seize the opportunity to get a higher rate of return
7/ / There are risks
There is a reason why people say debt is risky, because it can be
When the price of an asset declines, things get ugly quickly
Let’s look at Scenario 2 again, and assume that the price of the house when you decide to sell drops to $50,000
There is a reason why people say debt is risky, because it can be
When the price of an asset declines, things get ugly quickly
Let’s look at Scenario 2 again, and assume that the price of the house when you decide to sell drops to $50,000
• House value: $50,000
• Mortgage: $80,000
• Initial investment $20k now worth $0
This is a situation referred to as being “underwater”
The value of the asset you own (the house) is worth less than the mortgage owing on the house
• Mortgage: $80,000
• Initial investment $20k now worth $0
This is a situation referred to as being “underwater”
The value of the asset you own (the house) is worth less than the mortgage owing on the house
Because of the decrease in value of the house,
Your initial investment is worth zero. Your $20,000 is gone
In fact, you owe the bank more money than what the asset you purchased is now worth
You sometimes have to make up this difference using money from your own pocket
Your initial investment is worth zero. Your $20,000 is gone
In fact, you owe the bank more money than what the asset you purchased is now worth
You sometimes have to make up this difference using money from your own pocket
TLDR
• There is good debt and bad debt
• We use debt to buy assets we can’t afford
• Use leverage to boost returns
• Debt helps you get non-dilutive financing
• Look for return arbitrage
• Debt can be risky when prices decline
• There is good debt and bad debt
• We use debt to buy assets we can’t afford
• Use leverage to boost returns
• Debt helps you get non-dilutive financing
• Look for return arbitrage
• Debt can be risky when prices decline
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