Responsible borrowing – using debt to make money
Do you know how you can use debt to grow your wealth?
Settling your existing high-interest debt can often provide a better return on your money than putting your spare cash into an investment.
On the other hand, taking on new debt to buy an asset that has the potential to appreciate or generate an income (be it a rental property or a business) could accelerate your growth significantly, while also providing you with certain tax benefits.
Understanding debt
While debt often carries a stigma, not all debt is bad. In fact, if used smartly, debt can be a great tool to accelerate your financial plan and wealth creation. Debt can also be an efficient tool to optimise tax, and if you manage your debt well, it can help build your credit profile, which, in turn, will unlock access to more finance.
The trick is to know which type of finance to use for what purpose, and to differentiate between good and bad debt to avoid the latter.
What is good debt, and what is bad debt?
Good debt is money that you borrow to generate income and grow your wealth. It is the type of debt that, in the long run, makes more money than it cost you initially. In many ways, good debt can be regarded as an investment.
Bad debt, on the other hand, is debt that you can’t afford to repay because of poor money management or lifestyle choices. Buying more clothes or accessories on credit when you don’t really need them, and then running into trouble with repayments, is a good example.
Some debt is considered neutral. This is debt that is unavoidable, although it doesn’t necessarily generate a direct benefit.
The interest rate on your loan matters, which is why you should try to maintain a good credit score
If you want to invest in assets that will help you grow your wealth, you need to consider the pros and cons thoroughly. Consider your income, regular expenses and financial goals over the short, medium and long term. This will help you decide how much you can afford to borrow and what kind of debt is right for your needs.
3 examples of good debt
1. Property
A home loan, generally speaking, is good debt. It generates income if you buy a property to rent out, and if you buy it to replace a home that you currently pay rent for, it will save you money in the long run. The underlying asset also delivers capital gains, as the value of the property usually increases over time.
Commercial property is an investment that can start bringing in a steady income from rent the moment you buy it, which helps offset the payments on your property loan. The value of commercial property can also appreciate over time, especially in a desirable area with low vacancy rates, so it’s another reliable way to diversify.
Whether you buy property to let residentially or commercially, however, you will require significant capital to buy and maintain investment property, so it can be challenging for individual investors. Outsourcing management and maintenance to a property management agency adds to the cost of your investment, but it may prove worth it to save you time and effort, while ensuring efficient rent collection.
This is a long-term commitment – you need to be confident that the property and the area will both remain attractive to tenants in the future. Before borrowing to buy property as an investment, therefore, you should discuss your options with your relationship banker and with a commercial-property expert familiar with the area.
2. Education
Education will increase your capacity to earn a bigger income in the future, which in the long run should far outweigh the cost of a student loan.
3. Business ventures
Whether you are financing machinery, property or stock for a business, assuming you have a sound business plan and structured your business appropriately, business finance exists to support business growth.
Interest rates are important
You can borrow money for any need, provided the debt is affordable and you use credit responsibly. Still, it’s always wise to work out how much a debt will cost you, especially if you’ll be repaying it for 5 years or more. The interest rate on your loan matters, which is why you should try to maintain a good credit score – this can help you get better interest rates on loans.
Getting the best possible rate on a loan is important. For example, if you took out a R10,000 loan with a high interest rate of 24.75% per year, to be repaid in monthly payments over 5 years, your monthly payment would be about R405. You would pay almost R24,305 over the 5 years (60 months) – with R14,305 going towards interest and other charges. If you took out the same loan at a lower interest rate of 10.75% per year, the monthly payment would be closer to R315. You would pay less than R18,900 in total over the 60 months, so the cost of the loan would be R8,900.
If you’d like to learn more about managing debt and investment responsibly, download The Essential Guide to Money Management.
