Debt sure has a bad name nowadays. Everytime I grab a paper, all I see are reports around the “sovereign debt crisis.” When I switch on the tv, I’m bombarded with commercials from firms offering to help individuals with their “debt troubles.” I can see why many people today see debt as a disease, something to steer clear of like the plague. That’s too bad, because I feel debt is one of the greatest innovations ever, and possibly the number one tool for building wealth.
There’s no doubt: Lots of people and even some major nations today are battling with debt. Even so, debt is not responsible for all the misery, individuals who used the debt are at fault. Debt isn’t really something that is good or bad by itself. How debt is used determines whether an outcome is good or bad. Similarly, fire is not good or bad by itself, but how fire is used establishes whether an outcome is good (i.e. a campfire) or bad (i.e. a forest fire). Debt and fire have got one more thing in common: When used incorrectly, you can get badly burned.
Let’s look at a definition for debt. In basic terms, debt is a promise between a borrower and lender, where the lender gives money to the borrower, and after a period of time the borrower gives the money back with interest. Some financial gurus categorize debt as either good or bad depending on what the money was used for. For example, money that was borrowed to buy something that is expected to appreciate in value (like a house or investment) is regarded as good debt. Borrowed money used to buy something that depreciates (like a car, TV, or vacation) is commonly considered bad debt.
A lot of today’s debt troubles started back in 2005. At that period of time, people all over the world were using cheap debt to acquire real estate at increasing prices. Many people believed real estate prices always increase, so the debt they were taking on was “good debt.” Yet, what the majority of people didn’t see at that time was the housing bubble that was developing. Real estate assets were purchased at amazingly inflated prices during the peak of the bubble. When the bubble eventually burst and housing prices came falling down, many people were saddled with large amounts of debt and houses worth a small fraction of what was paid for them.
There’s a lot of blame to go around after the real estate bubble. Some of the many guilty parties include shady lenders, morally corrupt Wall Street bankers, incompetent regulators, and delusional buyers. In the end, like most financial calamities, the principle emotion driving all the madness was greed.
So understandably, plenty of people see debt as pure evil. However, the ugliness of the real estate collapse must not hide the many advantages of debt. For instance, debt is used to fund many public jobs like hospitals, schools, roads and bridges. Debt also gives companies and business owners the necessary capital to develop new products, broaden new markets and grow the overall economy. Without debt as a tool to finance new ideas, innovation would grind to a stop
Debt is a very good tool to move money from those who have it to those who need it. Virtually every successful wealth builder has used debt at some point. Here are some examples: The founders of Starbucks had to borrow $5000 from a local bank to keep their first store in Seattle afloat. Starbucks went on to become a Fortune 500 company. The founders of Apple, Steve Jobs and Steve Wozniack, were penniless when they started out and had to make use of credit from a supplier to build the first computers they sold. Apple is now among the most valuable companies in the world. There are countless other accounts of individuals building successful businesses and creating huge amounts of wealth by starting with a small loan.
Today’s scenario could be giving way to a new opportunity for creationing wealth. Interest rates are still at historic low levels, stock markets are stagnant, and some companies appear to be inexpensive judging from their fundamentals. This may explain the small pickup in merger and acquisition activity recently (see Ernst and Young’s latest Q2 tracker of M&A deals). Strong corporations may be realizing that they can buy quality assets at cheap prices and fund it using cheap debt. The same prospect may be emerging for individual investors as well. Some excellent blue chip companies have come down in price, giving individuals an opportunity to “buy low.”
Obviously nobody knows the future. The sovereign debt crisis could get a lot worse, the stock market could fall further, or a new catastrophe altogether could pop up. But it’s times like these, when fear is running high that many smart investors can buy good assets on the cheap. Using debt is a way to potentially multiply that advantage.
There will always be risks to using debt (as the real estate bubble clearly shows), so anybody thinking about borrowing to invest should check with their professional advisor. However, using debt to buy quality assets when prices are cheap significantly mitigates the risk, and could lead to a significant increase in your wealth. Don’t get me wrong. It is possible to build wealth without ever going into debt, but if you are serious about building wealth, you should have debt ready and at your disposal.