In finance there is both bad debt and good debt. Bad debt is owing money on depreciating assets that have fixed payments and go down in value. Good debt is owning an asset by using debt that goes up in value and/or creates positive cash flow above the debt payment and expenses. All debt comes with risk but some debt pays you to have it while other debt you pay to own.
How does debt make you rich?
Debt can make you rich when you use other people’s money to control assets that appreciate in value and create cash flow that grows your net worth. Good debt creates leverage, for a small monthly fee you can control an asset worth many times the monthly payment. Your gain is a percentage of the asset you control not on your payment.
Many businesses start with business loans so the owner can get access to capital in the first stages of opening and operating. While the banker owns the right to the interest on the debt and the payments the business owner owns the business itself and the value of the future profits and cash flow. Debt gives people the capital they need to create assets of value. With debt and credit everyone can be a capitalist.
How do rich people use debt to their advantage?
Rich people use debt to multiply returns on their capital through low interest loans and expanding their control of assets. With a big enough credit line their capital and assets are just securing loans to be used in investing and business. Their assets can be earning returns at the same time their borrowed money is at work creating returns and growing their net worth.
5 powerful ways to use debt to build wealth
Leverage in Real Estate
Buying real estate allows you to leverage your capital by multiples of twenty with 5% down payments or multiples of one thousand with monthly payments. For a down payment of $10,000 a real estate investor can own a $200,000 house with a $2,000 monthly payment. Real estate investors make returns on the full amount of the loan not just the money put into the investment. If the piece of real estate goes up 20% in value from $200,000 to $240,000 then the $10,000 down payment creates a 300% return with the $40,000 investment return.
Debt can also be used to buy monthly rental properties or houses to be used as an Airbnb to create cash flowing assets for monthly income through leverage. The returns in cash flow is on the total debt not the money invested in the property creating great returns.
Leveraged Buy Out
A leveraged buyout (LBO) happens when the buyer or buyers of a company takes on a large amount of debt as part of the purchase process. The buyer will use assets from the purchased company as collateral to acquire the company with plans to pay off the debt later after the buyout using future cash flow from the company. After a leveraged buyout, the buyer ends up with controlling interest in the target company.
Selling short reverses the normal order of buying and then selling stocks. Selling short means to sell something you don’t own. When you sell a short stock you borrow the stock from your broker and sell it to a buyer. You then owe the broker the shares. You receive cash from the sale but have to use it to buy the shares later to pay back your broker for the loan of shares. You are long cash and short the shares on a short-side trade. You’re in debt for shares using the credit available in your margin account.
When you buy to cover the short position that will be your debit purchase price to buy back the shares you were short in the open market, then your broker can return the shares to the account they were borrowed from. This is all done electronically today and is computerized and automated.
A short seller reverses the sequence of trading, they sell first and then buy back later. If you sell short for a higher price than you buy it back later for, you have a profit using debt. While you are short a stock you will also have to pay a margin interest on the position size held. You will also have to pay any dividends due on the stock during the time period you are short. This is how traders can make money in both directions of the stock market, when it goes down as well as up.
A margin account is is a type of brokerage account where the stock broker lends the investor cash or shares, using their account as collateral to purchase securities. Margin trading is when your broker adds buying power to your account to increase the size you can trade and the quantity of trades you can make. Margin can be used to add leverage to your trades or for faster turnover on your trades without having to wait for them to clear after entering and exiting.
If margin is used to increase the size of your trades then your results are amplified. If you trade twice the size of the position you would have traded without margin, then your wins are twice as big but also if it’s a losing trade it would be twice as big of a loss.
Margin accounts allow investors and traders to generally double the size of their total trade position sizing if the stocks they buy are able to be used for full margin. Margin more importantly allows day traders to maintain buying power without needing to wait for all their trades to clear.
Using Debt for Living Expenses
Investors can pay living expenses using debt to avoid income tax and taxable events like selling assets for capital gains. For example they can use a margin loan on their portfolio holdings with their broker without needing to sell any of their stocks at the moment and then pay it back later by selling stocks that are down creating no capital gains tax.
High net worth individuals can also live off lines of credits backed by their assets and only pay off their loans from sources with optimal taxing structures. Like the sell of a personal residence that are not taxable in most states, selling losing investments, dividends with a lower tax rate than income, margin loans, or capital gains from stocks that have a lower tax rate than a high tax bracket.
How do billionaires live off loans?
As an example of a wealthy person making money from debt by optimizing their tax liability let’s look at Elon Musk as an example. When the richest man in the world needs some cash, he has the ability to borrow money and use debt for living expenses or trying to acquire companies like Twitter. He can use his holdings of Tesla shares as collateral for credit lines, as an alternative to selling his shares and then having to paying capital gains taxes on the profits of a sale. His pledged shares of Tesla serve as an ongoing credit facility, giving Musk access to billions in cash whenever he needs it for any purpose.
Image created by Holly Burns