People often think about debt as a bad thing. When you mention to someone that you have debt they look at you as if you just said a bad four-letter word. In some cases, debt is a bad four-letter word but in the right circumstances debt, it can actually be a good thing. What many people don’t realize is that when used properly debt can substantially increase your net worth. The problem is most consumers in America use debt to decrease their net worth and increase the junk pile in their garage and that is the improper way to utilize debt. Generally, debt should be reserved only for investments to increase your net worth. When used for investments we call debt “leverage.”
As investors, we use leverage to minimize the capital that we have to provide upfront to make an investment. This allows us to potentially increase our gains beyond what we could have gotten if we had only used our cash to make the investment. Imagine that you run a computer business and I’m your inventory supplier and I sell you a computer for $100 but instead of you having to pay me the whole $100 upfront I give you the option to pay me $50 now and $60 12 months from now. You will be in debt to me for $60. Now imagine that 2 months after I sell you the computer you turn around and sell it for $200.
You can now pay me the $60 you owe me and you get to keep $140. So in total, you paid me $110 and you got to keep $90 and all you had to pay upfront was $50 to make that $90. That’s using leverage to increase your net worth. You went into debt in order to make an investment and turn a profit. So if you didn’t have the whole $100 upfront in cash you would’ve still been able to make that investment and make that profit. And if you did have the whole $100 in cash upfront instead of buying one computer to turn around and sell you could’ve bought two and increased your profit even more.
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Now on the other hand leverage can also be dangerous. Imagine that you weren’t able to sell the computer for $200 and you were only able to sell it for $50 because a new model of computers just came out and it decreased the market value of the computer you’re trying to sell. Well now you only have $50 to pay me back but you owe me $60. This is where leverage can turn around and bite you. You’ll be forced to take a loss on this transaction and pay me the extra $10 out of your pocket for a total of $110 when you could’ve only had to pay me $100 if you had paid cash upfront.
Now if you wanted to make things more complicated you could double down on your investment and take the $50 that you made from the sale of the computer and come back to me to buy another computer for the same deal I gave you on the previous computer, $50 upfront and $60 in twelve months, and you could try and mark up the price on that computer to try and break even but that’s way more complicated than we need to get. And that double-down strategy can get you in much more trouble than you were originally in.
Smart, wealthy investors aren’t afraid of debt and they utilize leverage in their investment portfolio to increase their potential profit and free up their cash for other investments or purchases. When you use leverage in your investment portfolio it’s called trading on margin. The basics of trading on margin are that the bank will allow you to purchase a Motley Fool stock pick without having to pay the full price for it right away. The bank basically gives you a credit line and will require you to pay a percentage of the total purchase price of a trade upfront and you won’t have to pay any more as long as the price of the stock rises or doesn’t fall to a certain level.
If it falls to a certain level you will have to make a deposit into your account which the bank calls a “margin maintenance call.” This deposit buys you more time to hold on to the stock in hopes that it rises and you don’t have to take a large loss. If you fail to deposit money into your account on time the bank has the right to, and will, sell the stock to recover their money. In order to use this margin feature, you will have to pay interest on the amount you “borrow” from the bank and the bank will require that your portfolio have a certain value at all times. Margin interest is better than credit card and personal loan interest for two reasons.
One, it’s usually lower than credit card interest or loan interest. Two, it’s possibly tax-deductible. This is because the government likes to encourage investing and so they allow you to get tax breaks for investment expenses. Just note that trading on margin is only for experienced investors and again, using leverage can be very risky and very dangerous therefore you should avoid it and leave it to the professionals if you don’t know what you are doing.
You will find that very few people, if any, have built wealth without utilizing debt. So before you swear off debt you should take time to think like the wealthy think and see debt for its potential advantages. Money is a tool and debt is a foundation to build upon when used properly. Don’t fear debt, embrace it and make it work for you.
Author Bio: Jerry D Mitchell II is the owner, CEO, and Principal Financial Advisor of Incite Wealth Management LLC, a fee-only registered investment advisory firm in Orlando, FL. Jerry’s passion is closing the wealth gap by increasing the financial literacy of young professionals and underserved minorities. To connect with Jerry you can follow him on Twitter @The_iAdvisor.