personal finance

Can debt make you rich?

by Khatapana

Aug 5, 2022 - 5 min read

Can debt make you rich?
We all probably have heard about cases where people have lost all their fortune to their creditors after defaulting on their loan. The instances of bankruptcy are not uncommon at the organizational level as well. The importance of saving felt by many of us is generally borne out of the fear of the urgency to take loans, in which we might default and lose everything.

But are all debts that scary? Having enough savings to make big purchases is not always feasible. And in some cases, it is not financially smart as well. However, making such big purchases may be essential to get rich. Debt can play a key role in reaching some major personal milestones in your life. Getting a degree, starting your business, investing in your first real estate, etc. may not be possible without debt as they require larger investments, that can exceed your current bank balance.

The idea that you have to stay out of debt to be successful may be a LIE after all. Certain debts provide opportunities for the future if managed responsibly. However, one should be able to differentiate good debts from bad debts. No matter the type of debt, the most important question that determines the goodness of your debt is: Will this debt pay me back more than what I put in?

Before borrowing, you need to consider several facets of the debt: interest rate, principal and interest payment schedule, loan tolerance, and most importantly, the objective of the loan. If the debt still makes sense after factoring in principal and interest payments, potential late fees and penalties, opportunity cost, loan tolerance, etc. then the possibility is, that it is good debt. Some of the good debt practices are explained below:

Liabilities for Assets or Liabilities for Liabilities?

As Robert Kiyosaki had suggested in his book Rich Dad Poor Dad, in your personal balance sheet, prioritize adding assets through your equity and liabilities, rather than adding more liabilities through liabilities. Kiyosaki’s definitions of assets and liabilities are quite different from the technical accounting definitions. According to him, assets are anything that generates income, like real estate investment, stocks, business, etc., whereas liabilities are anything that takes money out of your pocket like cars, vacations, weddings, clothes, etc.

A car depreciates in value over time, and it demands periodic operational and servicing expenses. It doesn’t add value to your personal wealth. Hence, Kiyosaki considers the car a liability. On the other hand, land leased to a resort is an asset. It generally appreciates in value over time and generates periodic income through lease payments. Buying a liability (car) with liability (debt) may not make you rich, but buying an asset (land) with a liability (debt) can generate income (lease payments, capital gains) and make you rich.

Source: Rich Dad Poor Dad by Robert Kiyosaki

Hence, inefficient debts i.e., debts associated with possessions that depreciate in value, or cannot generate income and tax benefits should be avoided or at least minimized, as they are likely to reduce wealth due to interest, expense, and depreciation. Efficient debts i.e., debts associated with possessions that have the potential to grow in value or generate income, that can be used to pay back the debts,should be prioritized as they can help you to build your personal wealth over the long term.

Borrowing to Invest

We are not unaware of the role of investing to build wealth. If you had entered NEPSE with Rs. 1 lakh investment in Salt Trading Corporation 10 years ago, today’s worth of your investment would be a whopping Rs. 1.83 crores. A recent report by NRB suggests that the land prices of the valley are increasing by 27.7% a year and doubling every 3.5 years. Many Nepalese who had invested in properties and shares a few years ago belong to the new rich class of the country. However, you may not be able to afford many investment opportunities with your personal savings. This is where the role of debt becomes significant.

If your investments increase in value over time, borrowing can enable you to purchase more investments and generate a higher overall return, after factoring in interest and other costs of debts. Capital gain and income generated from assets can be used to pay back the debt and interests. The opportunity cost of not using debts in these scenarios may be much higher than the risk of getting defaulted.

Having said that, you should not ignore the risk of your investments and the possibility of your investments decreasing in value. You should also not overestimate your ability to afford the repayments. To avoid falling into the debt trap, you need to carefully evaluate your investment decisions and your affordability to pay back the loan.

Borrowing to Invest in Self

Debt to fund your education can be good debt considering the positive correlation between a college degree and higher earnings. Education can be expensive. However, education can open many doors for you in your career, where you can utilize the learned skills and knowledge to earn money. Hence, choosing to walk away from this opportunity, because you don’t have enough personal funds could be a mistake. If the return from investing in education is higher than the cost of getting one, then it’s definitely worth it to be indebted. However, you need to be mindful of the interest and principal payment terms, your debt tolerance, and your expected earnings after your degree before taking educational loans.

Debt to Begin Entrepreneurship Journey

If it’s money that’s stopping you from starting your own business, consider taking business loans.Starting your entrepreneurship journey can be daunting, given the financial constraint. For a handicraft business, for instance, you might need funds to rent up a space, buy interiors, purchase inventories, hire staff, advertise, and for other costs and expenses to get started. You may not have enough to fund all these activities properly. Small business loans can enable you to take the leap, fund your business idea, and expand your possibilities. Debt can be one of the first steps to creating your own wealth-building machine.

Debt Recycling

This strategy involves converting your inefficient debts, that don’t generate capital gains, or income or aren’t tax deductible, into efficient debts that generate capital gains, or income or are tax deductible.

For instance, with the money you were going to invest in stocks, you pay down your home loan instead. You then reborrow that money to invest with. This way, you will earn a higher return on your investment because you will be taxed less. Alternatively, the portion of the loan used to invest is tax deductible in contrast with your equity.

To pay off the non-deductible home loan, income from investment, regular savings as well as tax savings can be materialized. The goal here is to make the non-deductible home loan smaller, and shift its weight to a tax-deductible investment loan until you’re left with only an investment loan.

Having said that, debt recycling is not for everyone. You should be financially smart and invest yourselfto actively manage your money. Or else, you might get stuck in an even bigger debt spiral.

All in All

As fast as good debts can make you more wealthy, bad loans have the power to make you poorer even faster. To make debts work in your favor, they should be used to invest in efficient assets that are likely to give you higher returns than the cost incurred on them. Financially smart people should also make sure they can afford the cost of debt and that there will be enough financial breathing room for them. Only after ticking off all the parameters of good debt, they should move forward with the decision.

Using debt to get richer may go against conventional wisdom as debt is seen as a downward pull on an individual's finances. However, if used and managed smartly, debt can break your limits and expand your horizon, empowering you to take bold decisions towards financial progress.

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