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Growing Wealth by Gearing
In Hamlet, one of his most famous plays, William Shakespeare has fussy old Polonius advise his young son Laertes, 'Neither a borrower nor a lender be'.
This could be good advice for an inexperienced young man leaving home to go to university in another city, but if we followed it, many of us would end up a lot poorer.
For a start, anyone who has ever put their savings into a bank fixed deposit or term investment is a lender - lending your money to the bank in return for the interest.
And of course, most of us would never own our own home unless we borrowed a substantial amount of money from the bank in the form of a mortgage. And since buying a home allows us to stop paying rent and start paying for an asset that will one day almost certainly be worth a lot more than we laid out in mortgage repayments, it is obviously a good thing to do.
So if we agree that borrowing is not always a bad thing to do, the question is, when is it good to borrow and when is it bad? There are basically three different kinds of borrowing, and it will pay you to understand the differences between them.
Bad borrowing is borrowing simply to spend, either on day-to-day things like clothes, or on things that lose value from the day you buy them, like cars and washing machines. This is the typical credit card or car or home appliance finance debt, and it is the worst kind of borrowing.
Some people may not realise that when you buy on your credit card or through a finance company, you are actually borrowing the money. This is always a very expensive loan, because what you buy soon ends up being worth much less than you paid, yet you are charged very high interest rates on the loan. (If it's paid for, better to make the old car last another year or two if you can).
Neutral borrowing is when you borrow money to buy an appreciating asset, but are legally unable to claim any tax rebate on the interest you pay. Standard home mortgages fall into this category because home mortgage interest is not tax deductible. This is a great pity, because over the lifetime of the mortgage, you will probably pay more than twice the value of the original loan in interest. That is why you should pay your mortgage off as soon as possible to reduce the total interest bill.
Good borrowing that can actually fuel personal wealth creation is when you borrow to buy an appreciating asset such as land, real estate or shares. Not only is the asset you buy likely to increase in value over time, but the interest you pay on the loan is tax deductible. So depending on your income and your tax bracket, you could end up borrowing for investment virtually tax-free.
Good borrowing is achieved by arranging a line of credit or a personal loan from a bank or financial institution - usually no problem if your home is partly or completely paid off.
Once you know you can borrow the money, the next question is, what asset will you invest it in? And can you be sure you will end up making more money than you borrowed when the time comes to sell it? Sometimes the answer to that question is not so obvious.
Would you borrow $100,000 at 17% interest per annum (p.a.) for 25 years to invest that borrowed money at 7% p.a.? The immediate answer would probably be a loud NO!
How can you make money if you are borrowing it at 17% and investing it at 7%? An impossible feat? Not at all. Let us show you how it is done. The table below shows how you could borrow at 17%, invest at 7% and come out more than $100,000 ahead.
This table might surprise you. At the end of 25 years, you would have paid back $431,340 - the original $100,000 you borrowed plus $331,340 in interest at 17%.
However, if you had invested the $100,000 you borrowed at 7% compound interest for the same period of time, you would end up with $542,743 in your account. Deduct the $100,000 you borrowed and you are left with $442,743, so you come out more than $111,000 ahead. And not only that, you might also have claimed a tax deduction on the $331,340 you paid in interest! (Though you may have to pay some tax on the capital gain of your 7% p.a. investment).
Now you have learned that you can pay a higher interest rate to borrow money than you earn by investing it, providing you build the investment capital by reinvesting the interest, and providing you leave enough time for it to build up.
However, this is not the most important lesson. The most important thing you have just learned is that the first rule of wealth creation is to look at investment in a different way.
The easiest way to do this is to look through the eyes of someone who not only understands investments, but also knows you well. In other words, a trusted financial adviser.
We would very much like to be your financial adviser to help you look at the potential advantages of borrowing in order to invest. It may not necessarily be the answer to every investor's prayers, but it can be a very rewarding strategy if it is done correctly.