Using debt to build wealth

While majority often equate debt free status to financial health, the same may not hold true. Experience has shown that most people who spend most of their lives striving to be debt free end up poor or with no tangible wealth altogether.

While majority often equate debt free status to financial health, the same may not hold true. Experience has shown that most people who spend most of their lives striving to be debt free end up poor or with no tangible wealth altogether.

Except for a few cases like inheritance, bequests or jack pots, it may not be practical to generate substantial wealth from savings alone.

Wikipedia defines debt as money owed by one party, the borrower or Debtor to a second party, the lender or Creditor. The borrower may be sovereign state or country, local government, company or an individual.

At macro level, no know country has developed without dept. Indeed, whereas Western countries have been quick to lecture African countries on their levels of debt, it is not lost to observers and analysts that the countries with the highest dept levels to GDP are found in developed economies. This again notwithstanding what other countries owe these countries.

As of the end of 2017 for instance, the United States of America’s dept was 105.4% of Gross Domestic Product while by 2016 Japan’s was 250.40% according to Dept Sustainability Analysis Report by the World Bank. Comparatively, Rwanda public debt was 37.59% of Gross Domestic Product as of end of 2016.

Just like governments need debt to finance large development projects and companies for expansion or large purchases to grow, so do individuals need debt to fund good investment ventures that ordinary savings or cash flows may not be sufficient to achieve.

While debt remains a powerful tool for building wealth, the same may bring sorrow to many. For one to realize tangible positive value of debt, one must first formulate individual debt strategy and policy which must be reviewed regularly.

The dept policy determines amongst other things the cost of debt, usage and duration. This then enables one to distinguish between a good and bad debt. A good debt is utilized to make investments that have returns that enable the Borrower to repay the loan and retain some earnings. Ultimately, the debt is repaid in full leaving the Borrower to continue earning from the initial investment.

For a debt to be good, it must be invested in assets that have good cash flows. An example of good debt is when a loan is invested in a property that has enough rental income to repay the loan. To the contrary, a loan used to purchase a residential house for own occupation may be bad if the hypothetical rent is higher than previous cost of rent immediately before occupation. Depending on cost, source and duration, this may leave Borrower worse and even default on repayment.

A bad debt for an individual does not have the conventional meaning in banking where it refers to the possibility of recoverability. A dept is deemed as bad or good depending purely on the cost, where it is channeled and the outcome of the use.

When debt is used for consumables like credit cards or expenditure advances, then it becomes bad no matter whether one is able to repay or not as the debt only takes away money from ones pockets without bringing any income back. Regular use of poor debt instruments like credit cards and advances have the effect of condemning one to debt cycles. Besides that, such instruments also have hefty hidden costs that only helps the issuer to exploit the Borrower further.

Whereas the use of debt is inevitable is building wealth, it must be noted that there are some assets that one cannot use borrowed money to invest in. One such asset is shares or equities. Because of the volatility in stock markets and their very long term nature in returns, it is not advisable to use debt to investment in stocks. One may however use short term loans to accumulate equity investments over time so long as the purpose is to realize returns in the long term. This is particularly an option for those who do not have the discipline to save.

As in the case of commercial banks that principally make their wealth from interest margins between rate on savings and loans, individuals alike may make money using the same means. Nothing for instance prevents one who is able to secure cheap credit of say 6% from any source to invest the same in Government of Rwanda Bonds some of which have returns of over 13%. Such an investor would get the difference in rate as profit by simply using other people’s money. A word of caution however is that one must understand the actual cost of money and the net return before deciding on using borrowed money to invest.

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