If you follow any financial gurus, you’ve probably already been warned to stay far away from debt. This has conditioned you to believe that all debt is bad and should be avoided. However, debt can be a powerful tool when it comes to building wealth. In fact, countless millionaires still carry debt.
In this article, we’ll cover the difference between good and bad debt and how to use debt to build wealth.
Good Debt vs Bad Debt
Debt refers to any time you’re borrowing money, such as personal loans, real estate loans, car loans, student loans, and installment loans. Credit card debt is also a common form of high-interest debt debt. Any money you borrow from an external party with a promise to repay is considered debt.
The difference between good debt and bad debt is how you use it and the interest rate. If you are using debt to make unnecessary purchases and live outside your means, racking up a credit card balance will lead to high interest payments. This won’t get you very far. On the contrary, debt is beneficial if you use debt as leverage to buy assets that produce income or grow in value.
In addition, debt is generally considered good when the associated rate is less than the average return of the stock market, which is 10%. Bad debt exceeds the 10% threshold, like a credit card balance with a 26% annual percentage rate. To build wealth using debt, only take out good debt that will produce a financial benefit.
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How to Use Debt to Build Wealth
Here are a few different ways in which using debt to build wealth is a good thing.
Invest in Real Estate
One of the most popular uses of debt is to purchase real estate. Both residential and commercial real estate properties will generally have some type of loan attached unless you plan on paying cash. With the median home list price being $412,300 in Q2 2024, most real estate investors will need a loan.
Real estate is a tried and trusted way to build wealth, as 90% of millionaires became rich through real estate investments. Even if you are purchasing a home to live in, you start building equity through appreciation and loan paydown. Not to mention the tax benefits when filing your tax return.
Once you have your primary home, you can use debt to build your portfolio by adding rental units or flipping houses. There are numerous financing options, including home equity lines of credit, private equity, and traditional term loans.
Improve Contract Terms
Debt is the primary way to build your credit score. Lenders want to see that you are a responsible borrower, repaying your obligations on time each month. Showing good creditworthiness results in a higher credit score. Improving your credit score can unlock favorable financing terms and wealth-building opportunities.
For example, if you have a low credit score, you might not qualify to purchase a home, resulting in more money spent renting. On the contrary, if you’ve consistently improved your credit score through good debt, you might qualify for a home at a lower interest rate. Improving your contract terms puts more money back into your pocket each month, allowing you to deploy your capital to build more wealth.
Leverage Stock Market Investments
We have already touched on the power of real estate investing and building your credit score. Combining these two factors together can expand your wealth through stock market investments. Let’s say you have great credit and were able to secure a real estate loan at 6%. Based on historical information, the stock market generates an average return of 10% each year.
If you were to pay down your real estate loan, you would save 6% each year. However, if you were to invest that money instead, you could generate 10% each year. This 4% difference is known as a spread, and it’s what makes good debt act as leverage. By taking on low-interest debt, you have the ability to earn higher returns elsewhere and build your wealth.
However, remember that investing involves risk. If you’re not an experienced investor, you can hire a financial advisor or use a product like Ziggma, which can help you identify high-quality companies that meet your financial goals. Once you have an investment portfolio established, use the Ziggma wealth tracker to continuously monitor your portfolio and understand if changes need to be made.
Also Read: What are Unrealized Gains and Losses?
Purchase or Start a Business
The next way to use debt to build wealth is to purchase or start a business. Starting a business can be capital-intensive. From purchasing equipment and supplies to marketing and hiring staff, you might not have the cash on hand to fund your startup. The same applies to buying an existing business, which can be cash-intensive upfront.
Leveraging debt to purchase or start a business is a great way to build wealth. Businesses that are expected to generate profit and cash flow can better your financial position and open up new opportunities. In addition, there are government loan programs and grants that offer favorable financing terms.
Expand Your Career
An overlooked way that debt can build wealth is through career advancement. Taking out student loans to pursue a college degree can lead to higher earnings in your career. For example, if you go back to school and receive your master’s degree, would you be eligible for a pay raise or a new position?
When determining if expanding your career through debt is a viable option, look at the big picture. How much of a salary increase is reasonable over the rest of your career? If this number is larger than the upfront cost of expanding your education, you are building wealth.
Before you take on debt to expand your career, double-check with your employer to see if they will subsidize a portion of your education costs. You might be surprised to learn that employers are willing to pay for higher education if it benefits the company.
The Bottom Line
Knowing when you’ve taken on too much debt is important. After all, you don’t want to default on any loan payments. When using debt as leverage, be aware of variable interest rates on real estate loans and always have adequate cash reserves. Debt can be difficult to offload, especially if it’s tied to an asset like a house. Nevertheless, strategically using debt is a great long-term debt-building strategy.
Frequently Asked Questions
Is leveraging debt a good idea?
Leveraging debt can be a great way to build long term wealth, but you need to use the debt wisely. You can’t just take on credit card debt and expect to start building wealth. Instead, you need to have a plan in place how how you’ll use the borrowed money to earn a return that’s greater than the cost.
How do millionaires use debt?
Wealthy individuals will borrow money against their own assets to make money. For example, if they purchase an investment property, they could use a home equity loan on that property to purchase a second property. As those properties make money from rental income, they’re then able to pay down each loan.