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Debt as a tool for building wealth

Friday, August 11, 2017

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Warren Buffet, the world's successful investor, has famously said that in pursuit of wealth we should always try to avoid borrowing. But for the average person, is this realistic?

Without borrowing, how could many of us afford to buy a house, a car and other assets with our own cash while also ensuring that we have enough savings to cover any eventualities such as illness, or to ensure that we have enough cash saved for our retirement? For most of us, debt is a necessary tool to help us acquire basic assets.

Michael Lee-Chin, in an interview with Forbes magazine, has posited that one of the many ways billionaires acquire wealth is to “use other people's money”. It so happens that getting a loan from a financial institution is essentially a way of using other people's money. The key to borrowing is to make sure you do so responsibly by actively employing another one of Warren Buffet's investment tenets: “Never lose money.”

If you are going to take a loan, I find that it helps to use the following guidelines to determine whether this loan will actually be beneficial in helping to achieve your long-term goals, including wealth generation and planning for retirement:

1) What is the purpose?

If you are going to borrow, you must think seriously about what the loan is being used for. Ideally, if you are paying interest on borrowed funds, it should be in pursuit of acquiring an appreciating asset. In other words, funds you borrow should be used to purchase or invest in something that will increase in value over time.

If, for some reason, your loan is being used to buy a depreciating asset such as a car, you should consider the long-term value that it will bring to your life. Will it enable you to get a better job, improve or increase your income opportunities, or improve your standard of living in a quantifiable way?

2) Earn more interest than you pay

Now that you have ensured that you are borrowing for the right reasons, you need to ensure that your loan makes financial sense in the big picture of your long-term financial goals. When you borrow, you pay interest to your creditor. Which means that even though you are well on your way to owning a valuable asset, you will be losing cash while making your loan payments to your creditor. The cash you will lose while repaying a loan will be significantly higher than the original cost of the asset itself. That is, you will inevitably pay your creditor a lot more than you originally borrowed.

Therefore, when borrowing you should:

*Ensure that after your loan payments you will still have disposable income for saving or investment.

*Find investment options that will give you a higher return on your investment than it will cost you to borrow. For example, if you can borrow at 10 per cent but invest at 11 per cent or more, then you will earn net income that will help you to efficiently build wealth over time.

3) Earn positive cash flow

Another option for building wealth with debt is to ensure that your debt helps you to earn positive cash flow. That means you should be earning more cash from your assets or investments than you are paying out to the bank.

The method to achieve this is much more simple, but may be slightly more elusive for some borrowers. This option involves borrowing to purchase an asset that will generate cash flow such as rental property, investment in a company, or purchase of bonds or dividend paying stock.

This is one of the central investment tenets of the book Rich Dad Poor Dad by Robert Kiyosaki. This philosophy is simple: Only borrow if it will help you to earn more money. For many of us this is challenging, as the biggest loans we have are usually for the car we drive to work and the house we live in – neither of which tends to generate cash. If, however, you are able to leverage those assets to generate cash which can then be reinvested, you would be well on your way to building sustainable wealth.

BE CAREFUL OF UNSECURED DEBT

With interest rates in Jamaica being the lowest they have been in many years, and competition between banks at an all-time high, it is easier than ever to get credit. Banks are basically begging you to borrow. They entice you by lowering fees and offering you unsecured loans and credit cards, pre-approved of course, so that way you don't have to go through all the usual hassle of trying to get a loan.

As consumers this is great for us, because that means we have power in the market.

On the other hand, we must be careful of how we accept these offers and how we use borrowed funds. Unsecured debt and credit cards carry the highest interest rates in the market. They should not be taken lightly or used frivolously. Unsecured debt must always be used in accordance with rules 1, 2 and 3 above.

Needless to say, there are several other considerations to make when borrowing or investing that will be discussed in future columns. For most of us, borrowing is inevitable. However, if we try to consistently apply the rules above, then borrowing can be a great tool for building wealth instead of being a financial burden.

Claudja Williams works as a consumer advocate in the financial sector. The views expressed are her own.

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