Debt seems to make the world go round these days. Everyone I know has some debt, whether it be mortgage debt, student loan debt or consumer debt which is the worst of them all!
Whilst mortgage debt and student loan debt are necessary for most who want to get on the housing ladder or get a good education, there is no sound reason people should have consumer debt (credit card debt).
You see, being in “bad” debt erodes wealth. It is the number one wealth killer and one of the quickest ways to make you poor.
How to use debt to get rich
And the rich understand this and use this to get richer. In order for people to accumulate debt, someone has to provide the financing. So when someone gets into debt, they have to pay the debt back to the owner with interest. And this could lead to a massive loss of wealth for the person who is in debt, but a massive wealth gain for the person providing the debt.
Consumer debt can be good or bad and it depends on your point of view!
Let us look at the following example to see how this works:
Let us say James and Sarah each have savings of £10,000. Both have no debts of any kind, no mortgage or no student loan debt.
They also each have jobs where they are able to save £200 per month after paying all their expenses.
James has a bicycle, and he rides to work every day. Sarah on the other hand wants to buy a new car for £18,000 so that she can drive to work.
Sarah only has £10,000 so she borrows £8000 from James to make up this shortfall. The interest rate agreed on this borrowed money is 10 per cent to be paid out over a 5-year term.
Both seem happy with the deal. Sarah gets her brand new car, and James figures he will get a little extra income while doing no additional work letting his money work for him.
At the end of the first month, Sarah owes James £170 (£103 principle plus £67 interest).
As Sarah has £200 leftover every month from her paycheck after expenses as mentioned above, she will be able to save 30 a month and still have her 1-month-old car.
James on the other hand still has his savings lump sum of £2,000 (£10,000 minuses £8,000).
He also has £200 leftover from his paycheck as he has no debt payments to make. In addition, he now also gets £170 from Sarah.
So after the first month, James will have £2,370.
At the end of the first year, Sarah has £360 in the bank whilst Joe has £6,440.
Sarah’s car is still pretty new, and she certainly hopes it remains this way since she could not afford any maintenance on the car.
James on the other hand is feeling good. His bank account is increasing by £370 every month and he’s thinking about looking at new ways to invest in income-generating assets.
Two more years go by (third year), and there have been layoffs at work. Sarah is getting worried she might be negatively impacted since she only has £1,080 in the bank, and her car is not as new as it used to be.
If layoffs come or if her car fails her, she has got no buffer.
James, on the other hand, has £15,320 in the bank, more than enough to cover a few months if he were to be laid off.
After two more years (fifth year), it is time for the final payment on the car. Sarah writes that the last cheque for £170.
After 5 years, all Sarah has is £1,800 in the bank, a 5-year-old car that needs some new tyres, and a lot of stress about not having an emergency fund let alone any savings.
James on the other hand has £24,200 in savings after 5 years.
She hands over the last cheque to James and says thank you.
James interrupts her to say No, thank you, Sarah. You have made me quite rich.
Sarah does not understand this as she thought the loan was a very generous favour from her friend James. After all, she has driven a car for the past 5 years, largely because of the money James was willing to lend to her.
James says you have given me a great return on my money over the past 5 years. I gave you £8,000 and you have given me back £10,200 over the past 5 years. I should be the one thanking you.
*James could have made even more money by reinvesting any money he received from Sarah each month. James could have used the power of compounding. But to make this example easy to understand and visualise, I have made it simple and avoided compound returns.
Whilst the above example is extreme, it aims to show you how debt can be both an asset and a liability, how it could destroy wealth from someone and create wealth for another person. Debt, especially consumer debt has the ability to transfer wealth from the lender to the borrower.
The irony in the real world is that the people that do not have money need to borrow it and pay interest, thus digging a bigger debt. Meanwhile, the people with all the money lend it out with interest, thus creating a bigger stockpile, the rich get richer!
When thinking of building your wealth this way, by investing for passive income, the income you receive for not having to do any work, you should not limit yourself to lending money. Investing in stocks or property can have the same effect. You can also check out My top 5 assets that generate income actually worth owning.
When you buy a stock, you buy a share in the company. From that point onwards, the employees in a company are now working for you.
But you can be the borrower, the person in debt and still get rich. You can embrace debt as being good and use it as leverage to maximise your wealth.
Using Debt to your advantage and making money from it
Some people prefer to see debt as good and a way to become rich. You can embrace debt as a useful leverage tool to help maximise your wealth.
If you borrow it for the right reason, then it is a great way to get the ball rolling. Borrowing for a good investment may help you become rich.
Let us look at the above example again. James and Sarah both start off with £10,000 each and both have £200 a month leftover from savings.
Sarah again borrowed £8,000 from James but this time uses the money, together with her own £10,000 to buy an apartment for £18,000.
Sarah lets out this apartment and gets a rent of £200 a month. So whilst she still pays James 170 a month for the borrowed money, she now has £230 to save each month (£30 as per the previous example plus £200 rent).
If we go straight to the fifth year, Sarah will still have paid James £10,200 for his £8,000 loan. James still ends up with £24,200 as before.
But this time Sarah, who in the previous example only had £1,800 after the first 5 years, now has £13,800.
And on top of that, she owns an appreciating asset in the form of an apartment as opposed to a depreciating asset in the form of a car.
Assuming the house appreciates by 10 per cent a year, the value would now be £28,989.
That is a gain of £10,989 (3£28,989 minus £18,000).
So all in all, Sarah now has £42,787 (£13,000 plus £28,989).
Sarah has used good debt to get rich!