If you want to be rich you have to start a massive business or have a very high earning job right? While these both can contribute to you having an impressive net worth, there are many other means you can employ that will have your bank growing by the day. In fact, the rich use a money management strategy that the rest of the population have been dissuaded from altogether and in this article, I want to share with you how the rich use debt to grow their wealth so you can better understand what good debt is, how it works and ways you can use it to improve your financial situation.
The first question you probably have is why would the rich ever take on debt in the first place? Well, let me answer that question with a brief story about how your favorite robot, I mean Facebook founder Mark Zuckerberg, bought his house about a decade ago. In 2012, Mark Zuckerberg decided to move into a new home in Palo Alto which was located just three miles from Facebook headquarters. The house he bought was priced at around $6,000,000 and while that’s a large purchase for the majority of people, for the 40th richest person in the world at the time, it would be like having a penny drop out of his pocket. At the time of this purchase, Mark Zuckerberg was worth a staggering $15.6 billion and it would be safe to assume that he would have at least $6,000,000 in cash to use on this purchase. While he had the cash to buy the home, that’s definitely not how he funded the purchase.
During this time in 2012, Mark Zuckerberg had a lot of big things going on in his life. Not only was he taking Facebook public but he was also getting married and even with these life changing moments going on, he still found time to make another important financial decision which was to refinance his mortgage to a 30-year mortgage at a 1.05% interest rate.
That's right, even billionaires like Mark Zuckerberg are making monthly mortgage payments like you or me. Now, this decision may sound crazy to many people who don't understand how debt works but let me start by saying that it all comes down to opportunity cost. Opportunity cost is defined as “the loss of potential gain from other alternatives when one alternative is chosen.” For example, spending $50 on a T-shirt comes with the opportunity cost of not being able to invest that $50 investing into your portfolio. In a non-monetary context, the opportunity cost of going on a bad date could be the time that you could have spent with your friends and family instead. Whether you realize it or not, every single decision that you make comes with some form of opportunity cost and this is why Mark Zuckerberg decided to refinance his mortgage and take on debt. Simply put, he had much better ways to use that $6 million so it made more sense financially to finance his home rather than paying for it in cash.
While this strategy has proven to be effective for Mark Zuckerberg and many others, it is definitely not a globally accepted way of using money. Many individuals believe that debt should be avoided at all costs. If you're a big Dave Ramsey fan then you know he thinks that debt is evil. Dave’s opinion is that you should rid yourself of all types of payments and that you’re best off being debt-free. While this makes sense for some people, it's not the best strategy if you want to maximize the resources available to you.
You see, there is something called good debt and there is something called bad debt. One can keep you in financial ruins forever while the other one can allow you to realize financial gains that you never thought were possible. So, before we got into how you can use debt to improve your own financial position, I think it's worth going over the definitions of both bad debt and good debt so we can clearly identify the difference between the two.
While both good debt and bad debt are liabilities that would show up on your personal balance sheet, bad debt is typically involve any purchase or financial decision where you are using someone else’s money to finance your acquisition of a product or service that won't yield you any financial return. Common examples of bad debt include charging your credit card to buy the newest iPhone or financing your new car purchase. In both cases, you are using someone else’s money to acquire an item that won't give you any type of return. In fact, in the case of the car, you'll actually be assuming even more costs as you have to pay insurance on the car, incur maintenance fees and of course fill it up with gas. Simply put, whenever you spend someone else's money on something that takes money out of your pocket you're assuming more bad debt.
On the contrary, whenever you assume debt that you can use to make you money, you're taking on what we call “good debt”. Now given that debt can actually be used in a positive way, you may be wondering why people would even assume bad debt in the first place? I think this is worth going over so that you can avoid this type of debt as much as possible and can focus on acquiring only debts that will make you richer than you presently are.
Why People Have Bad Debt
The first reason, and probably the most justifiable, for assuming bad debt is because is you can't meet even your most basic of needs. The sad truth is that many people don't earn a large enough income to be able to support their basic expenses of housing, groceries and utilities and this causes them to put some of these expenses onto their credit cards (i.e. bad debt).
Unfortunately, there are a ton of people who can meet all these expenses yet they still take on more and more bad debt. My opinion as to why this phenomenon happens in the first place is because people simply lack the ability to delay gratification. For instance, there's nothing wrong with wanting to buy that new iPhone that just came out but there is an issue if you don't actually have the money on hand to buy it. Sadly, many people don't want to put in the time and effort to save enough money for that iPhone. So rather than being the laughingstock of their friends, because they are still using last year’s model, they decide to charge the purchase to their credit card which ultimately jacks up this already expensive purchase by an extra 20% due to their credit cards interest rate. At the end of the day, whether or not your incurrence of bad debt is justifiable, it's undeniable that bad debt has no part in someone’s personal balance sheet. When taken from this position, I can understand why Dave Ramsey is so adamant about people avoiding debt at all costs.
Unfortunately, I think Uncle Dave’s is throwing the baby out with the bathwater because he's also suggesting that you shouldn't be taking on other forms of debt, some of which can act as a useful resource. Let me share a few examples of how you can use debt to improve your financial life.
Examples of Good Debt
The first example of how you can use good debt to make you more money is by taking on student loans. Now, I’ll start off by saying that I think the education system at large could use a lot of improvements. Moreover, if you have the cash on hand to pay your tuition then you should do so. Unfortunately, most young adults don’t have tens of thousands of dollars lying around that they can use on tuition which is why the majority of them have to take on some student debt to go to college. Based on this financial conundrum, it's no wonder The United States is in more than $1.5 trillion worth of student debt.
For the purpose of this example, let's say you assumed $160,000 worth of student debt to obtain a four year computer science degree. After completing your degree, you've essentially outlaid all the costs that will be associated with this investment and now it's time to recoup these costs and realize your returns. Assuming your entry level position pays you $60,000a year, it would take just three years before you would have earned a gross amount of income that would have eclipsed the cost of your debt.
Payback Period = $160,000/$60,000 = 2.67 Years
Now you may argue that during these first three years you wouldn't have paid off this student debt and this would be true which means that the actual cost of this student loan is much greater than the $160,000 worth of tuition that you've paid. In fact, a 2019 study found that it takes the average college graduate just under 19 years to pay off their student loans.
During this time you would end up paying an extra $50,000 in interest assuming that your student loan has a 3% interest rate attached to it. Nevertheless, the total debt inclusive of 19 years of interest could be recouped in less than 4 years under the same parameters.
Payback Period = $210,000/$60,000 = 3.5 Years
However, you have one final pushback to this first example of mine and it’s that you could earn a salary without going to school where your investment amount would be zero. This is true so let’s compare annual earnings of both our demographics. A 2019 study found that those with a bachelor’s degree make, on average, $32,000 more than their less educated counterparts which would put the high school graduate’s salary at $28,000 a year. Let’s back that out and see what the timeline would be for just the gains that someone would receive from having completed a degree:
Payback Period = $210,000/($60,000-$28,000) = 6.6 Years
Whatever way we slice it, going to school does pay off over time.
But maybe you have no intention of going to college or your college years are far beyond you, how can you use good debt to your advantage? Well if you've ever bought a home or an investment property then likely you already without even realizing it! The second way people leverage good debt to increase their wealth is by taking advantage of low mortgage rates. Let's use the example of someone who takes out a mortgage from the bank in order to buy an investment property. Let's say that you buy a home worth $300,000. You put down 20% or $60,000 and assume a mortgage of $240,000 at 3% interest. In this case, your annual interest cost would be $7,200 a year. Assuming that the property appreciates at an average rate of roughly 4% and you're able to have a positive cash flow of $500 a month on the property, then you would end up with a total return of $15,600 a year which is actually just over 25% at the total amount of cash that you initially invested.
The third way you can use good debt to make yourself wealthier is to replicate our real estate example but instead by investing the money that you borrow into paper assets. Let's now go over how you can do just that!
Let's say that you have access to a line of credit at your bank that charges you 2% interest. If you're able to take out that money at a 2% cost and invest it into assets that will yield you at least 2% then you are effectively making a profit on the money withdrawn. Now, you may be wondering what types of assets can make you this amount of return and quite frankly there are a ton! Index funds have averaged roughly 10% returns over the course of their existence and even investing in peer to peer lending has proven to offer somewhat similar of returns.
Now they've gone over a couple examples at how you can use good debt to make you money I want to briefly explain why good debt isn't called great debt. Simply put, good debt is not called great debt because it still does come with a cost and associated risk and while I appreciate the saying “no risk, no reward” risks always need to be considered when making financial decisions.
Why Not "Great" Debt?
In the three examples I mentioned above, each one comes with their own associated risks. For instance, if you take at college program that leaves you without a job at the end and has very little career prospects, then your ability to recoup your investment is quite low. Whether you get a job in your field or you end up flipping burgers after obtaining your degree, the bank will still come asking for their money.
In the real estate example, if you buy an investment property and no one wants to be your tenant then again your returns may be less than what you had anticipated and you may put yourself in a lost position until you get your housing situation sorted out.
In the final example, there's obviously the risk that any asset you invest in may yield you lesser returns than you initially anticipated. For example, if you took out money from your line of credit at 2% and invested it in a stock that actually declined in value then of course not only will you have lost money on said stock but you will still have to pay back the bank for the money you borrowed. Therefore, while good debt does exist it's not great because it still does come with not only interest costs but its uses come with quite a bit of risk as well.
Who Should Avoid Good Debt
It's for this reason that I think that leveraging debt is not meant for everyone. I think that the benefit you'll yield from using good debt is positively correlated to your financial control and investing expertise. For instance, if you can't even managed the bad debt you currently have now, then I truly don't believe that you should be assuming more debt even if it's good debt. But, this is just one of the groups of people who shouldn’t be leveraging good debt.
The second group of people who should shy away from leveraging good debt are those that are very risk averse or who are easily stress out by their financial decisions. Even in situations where you are borrowing at a very inexpensive rate, taking on more debt still does come with a cost and whenever you use someone else’s money to try and make yourself more money, you are taking on more risk. For those who are risk averse, it may be better to invest only using your own money and based on your own risk tolerance levels. Not to mention, investing with someone else’s money may be simply too stressful of an endeavour for you and knowing that you're indebted to someone else maybe a situation you're not necessarily comfortable with.
The final group of people who should steer clear of using good debt are those who have not assessed the projected returns they will yield from assuming this good debt in the first place. There may be people who understand that leveraging low interest debt can make you wealthier but have never conducted a cost-benefit analysis of whether the investments that they want to put this money into will improve their financial position. An example of this could be someone who takes out money from the bank in order to invest in a hot stock that their cousin’s sister told them about. In this circumstance, this person is just gambling rather than making an educated financial decision and if things don't pan out then this person could be in a terrible financial situation, even if the money that they borrowed carries a relatively low interest cost. Therefore, while using good debt can make you more money it's not meant for everyone. Luckily, if you can master your money and use debt properly then you can certainly use it to make money like the rich!