Debt seems to make the world go round. Most people have some, whether it’s a mortgage, a student loan or consumer debt such as credit cards. Consumer debt is the worst of all.
A mortgage or student loan can help you buy a home or get an education. But there’s rarely a good reason to carry expensive consumer debt. Credit card interest is often over 20% a year.
Bad debt erodes wealth. It’s one of the biggest wealth killers and one of the quickest ways to stay poor.
How the rich use debt to get richer
For someone to borrow money, someone else has to lend it. The borrower pays the money back with interest. That can mean a large loss of wealth for the borrower and a large gain for the lender. The wealthy understand this.
Let’s look at an example.
James and Sarah
James and Sarah each have savings of £10,000. Neither has any debt, and each can save £200 a month after paying all their bills.
James cycles to work. Sarah wants a new car costing £18,000. She only has £10,000, so she borrows £8,000 from James at 10% interest, repaid over five years.
Both are happy. Sarah gets her new car. James gets extra income without doing any extra work.
Each month, Sarah pays James £170. In the first month, that’s £103 of the loan plus £67 of interest. After the repayment, Sarah has only £30 a month left to save.
James has £2,000 left in savings (£10,000 minus the £8,000 he lent). Each month, he adds his own £200 plus Sarah’s £170, so his savings grow by £370 a month.
| After | Sarah’s savings | James’s savings |
|---|---|---|
| 1 year | £360 | £6,440 |
| 3 years | £1,080 | £15,320 |
| 5 years | £1,800 | £24,200 |
After three years, there are rumours of redundancies at Sarah’s work. With just £1,080 in the bank and an ageing car, she has no buffer if she loses her job or the car breaks down. James has more than £15,000, enough to cover several months without work.
After five years, Sarah makes her final £170 payment. She has £1,800 in the bank, a five-year-old car that needs new tyres and no emergency fund. James has £24,200.
Sarah thanks James for the loan. James replies: “No, thank you, Sarah. You’ve made me quite rich. I lent you £8,000 and you’ve paid me back £10,200.”
To keep things simple, this example ignores what James could have earned by investing the payments he received each month. With compounding, he’d have even more.
What the example shows
The example is extreme, but it shows how the same debt can be a liability for one person and an asset for another. Consumer debt moves wealth from the borrower to the lender.
The irony is that people without money need to borrow and pay interest, digging themselves deeper. People with money lend it out and earn interest, so the rich get richer.
You don’t have to lend money directly to be on the right side of this. When you buy shares or property, you own assets that earn money for you. When you buy a share, the company’s employees are, in effect, working for you. Read our top 5 income-generating assets actually worth owning.
Using debt to your advantage
Debt isn’t always bad. Borrowing to buy an asset that earns money or grows in value can help you build wealth. This is called leverage.
Let’s go back to James and Sarah. This time, Sarah borrows the same £8,000 and combines it with her £10,000 to buy a small flat for £18,000. (The numbers are kept simple to show the idea. Real properties cost far more.)
She lets the flat for £200 a month. She still pays James £170 a month, but now she saves £230 a month: her £30 plus the £200 rent.
After five years, James still has £24,200. But Sarah now has £13,800 in savings instead of £1,800.
She also owns an asset that can rise in value, rather than a car that loses value. If the flat rose by 10% a year, it would be worth about £28,989 after five years. Her total wealth would be about £42,789: £13,800 in savings plus the flat.
Sarah has used good debt to build wealth.
The risks of leverage
Leverage works both ways. In real life, this example leaves out a lot:
- Costs: landlords pay for repairs, insurance, letting agent fees and periods without tenants. Buying an additional property in England also means a 5% Stamp Duty surcharge.
- Tax: rental profits are taxed as income.
- Growth isn’t guaranteed: 10% a year is optimistic. Property prices can stall or fall, and if they fall, borrowing magnifies your loss.
- Interest rates: if your borrowing costs rise, your rent may no longer cover them.
So borrow only for assets you understand, keep your debt manageable and always have an emergency fund. And avoid borrowing to buy things that lose value, like Sarah’s first car.
Disclaimer: This is not financial advice. When investing, your capital is at risk. Your home or property may be repossessed if you don’t keep up repayments on a mortgage or other loan secured on it.
Pedro is passionate about finance, marketing, and technology. He is a growth manager at several online projects and a former digital marketer for a fintech company.
