Imagine your bank is willing to pay you 12% on your savings account. With your meager $100 savings, you’ll be making $12 in one year. $12 profit isn’t something to be excited about. Then you discover, there is another bank across town that is willing to lend you $100,000 at 7% interest. In one year, you pay off your $100,000 debt with the interest of $7,000. But out of nothing, you have just created $5,000.
This exact scenario is unlikely to play out in the real world because banks are smarter than that. But this represents how the world of debt and finance works. Debt is used as leverage for transactions that the borrower could not afford under normal circumstances.
Here is a more practical way to look at it. I started a business selling jewelry with my little savings. I would buy from local dealers and sell to corporate workers. Then I met someone who introduced me to the opportunity of buying better quality jewelry and accessories at a lower price from outside my country. The problem was that I didn’t have the capital to travel and purchase in large quantities. I had two options; forfeit the opportunity due to lack of capital or take a loan. I chose the latter option and took a loan from a private lender. With this loan, I was able to travel, buy better quality products at a cheaper rate, expanded the business and gradually paid off my debt.
While Albert Einstein was credited for saying that compound interest is the most powerful force in the universe; economists and financial experts consider debt to be the most powerful force in the world of money, largely because debt has the potential to create wealth out of nothing. In this video, I’m going to share with you how to and how not to use debt to create wealth. Before we get to it be sure to subscribe to After School TV for more insightful videos like this.
Debt as an Asset
When we talk about assets, the general knowledge most people have is stock, real estate, intellectual property, or business. But most people never consider debt to be a valuable asset, let alone something anyone would want to embrace. How does the word ‘debt’ make you feel? Do you think debt is entirely a bad thing?
Most of us have a negative perception of debt because of what we were thought by our parents and society. Personally, I’ve often heard my dad say things like, “Any wise person should stay away from debt by all means” So we were raised to believe all debt is bad and should be avoided at all cost. But is debt always bad? Is it something that should be avoided at all costs?
It will interest you to know that while everyone runs away from debt, rich people run towards it. In fact, the world economy runs on debt. If everyone and entity stopped borrowing money, unemployment will go to an all-time high. The economy will slow down or even come to a halt in a matter of time. As much as debt has a bad reputation, we may not have had a modern economy without it. That is why there is such a thing as good debt and bad debt.
Good debt Vs Bad debt
Whether a debt is good or bad depends on several factors. There’s the interest rate and the amount of time it will take you to pay back the loan. Then there’s the matter of what you’re borrowing the money for. Bad debt is debt that is either too risky or too costly.
People often use debt to buy things that lose value like a car, vacation, or shopping loan. These types of debt are usually expensive because you pay higher interest rates and you are taking a loan for something that takes money from your pocket. Borrowing to support ongoing living expenses is not a good use of debt. Borrowing for business can equally turn around to become bad when things get out of hand or didn’t go as expected. Bad debt can ruin lives and send people down to the bottom if they are reckless. But debt can also make you rich if you are smart with it.
Good debt increases your cash flow, like with my jewelry business. Individuals, corporations and governments use debt at different scales as leverage to make purchases or finance projects that they could not afford under normal circumstances. For example, Dangote Industries got a $6 billion loan from different financial institutions, in addition to its own $3 billion to build an oil refinery in Nigeria. Even if they had the financial capacity to fund the project, they are better off sharing the risk with other financial partners.
Sometimes, the reason rich people take on debt is not that they don’t have the money, but because debt is cheaper. Take for instance. You have one million dollars in an investment that could potentially make you a 30% profit and you want to finance another one million dollar project that could fetch you a 35% profit. Most people will forfeit the 30% profit investment to go for the 35% investment. But rich and financially savvy people do it differently. They keep the 30% profit investment and access a loan at 15% interest to take advantage of the other opportunity.
Rich people have their money working for them at different investment capacities and use other people’s money to pursue other opportunities. In other words, while everyone is thinking “this or that” the rich people are thinking “this and that”. They make this possible with debt. A good debt gives you a greater return than the interest you pay on it whereas a bad debt simply takes money from you.
Why Banks Prefer to Give Loans to Rich People
A common complaint people make especially when it comes to access capital to finance a business or an idea is that banks only give money to rich people. First of all, if you are just starting a business, you don’t want to start with a bank loan. There are less riskier sources of capital you should assess. That aside, the reason banks prefer to give loans to already successful people at an even cheaper rate is because of risk factors and credit rating.
A rich and successful person with collateral is a worthy borrower for the financial institution because in the worst case, the bank can recover their money from the collateral. Also, a person or entity that has a track record of success is deemed more likely to succeed in the future than a regular person who has no business experience or successful track record. Since banks are in the business of making money, they avoid high-risk borrowers or at best offer them loans at a higher rate to compensate for the risk of defaulting.
In developed economies, a credit score is very important metrics for citizens. It is a number that depicts a customer’s credit worthiness based on their credit history. In other words, it shows how good or bad a person has been with taking and paying up their debt; and the likelihood they will repeat the same pattern with future debt. The higher the score, the better a borrower looks to potential lenders. However, in less developed economies where there is no credit scoring system, commercial banks tend to be less willing to issue loans to people without collateral or a proven track record of success.
You have to be smart with debt
Not everyone has the risk appetite to take on loans for investment purposes. If creating wealth with debt was as easy as taking money from one source at a 7% interest rate and putting it in another source with a guaranteed 12% interest while keeping the difference, everyone would be rich. You can create wealth by leveraging other people’s money. But debt increases your risk. You are obligated to pay your principal and interest whether you make profit or not. This is where debt tolerance comes in. Your debt tolerance is your level of comfort with a given amount of debt and term of payment.
Almost everyone takes on debt at varying capacities, but some people are more risk-tolerant with the amount of debt they can take. Debt that is above your risk tolerance could become a bad debt. If you make a mistake, your debt could turn into a liability. This is generally why most people run away from debt. But if you are smart with money, you can create wealth out of nothing with it.
As you can see debt doesn’t necessarily mean a bad financial situation. In fact, there are situations where you need debt to get ahead and build substantial wealth. But you have to be smart with debt because good debt puts money in your pocket. Bad debt takes money out of your pocket.
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