“ Debt is not good or bad but what you decide to use the debt for makes it so” –Akinfemi Onadele
Point to ponder
Be honest with yourself before taking on debt financing. This means you should not borrow money to spend, or to invest in stocks. Instead do what the wealthy do. Choose to use debt to achieve your investment goals, by using it to create cash flow.
Uche has 100 million naira in cash that she wants to invest in real estate. She visits her financial advisor who presents her with a number of options for how she can invest the money. Her advisor lays out three options:
Option 1: Buy a 100 million naira property for cash (zero leverage). If property values increase 10%, she will have gained 10 million naira on her principal. Option 2: Use N100 million naira toward the purchase of a N200 million naira property, using financing like a bank mortgage loan to cover the other N100 million naira (This produces 50% leverage). If property values increase 10%, she will have gained N20 million naira on her principal investment. Option 3: Put the N100 million naira toward the purchase of two N200 million naira properties. If her N400 million naira properties values increase by 10%, she will have gained N40 million naira on her principal. This is the power of leverage and an example of good debt. As you can see, debt can be useful for spreading the cost of purchases, making investments, or managing finances. However, it is dangerous if it cannot be repaid.
Need to Know
| Risk | The possibility of losing something of value |
| Interest rate | The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets |
| Leverage | Using borrowed capital for an investment, expecting the profits made to be greater than the interest payable |
| Good debt | An investment that will grow in value or generate long-term income |
| Bad debt | Expensive debts that drag down your financial situation are considered bad debt |
| Cash flow | The money that is moving (flowing) in and out of your business in a month |
Source: Google
Let’s consider the alternative to the above example. If values and/or rents stagnate or decline, the advantage provided by leverage can quickly disappear, as Uche’s loan payments increase her carrying cost for the property. Considering that Nigeria is double digit interest rate environment, things can turn pretty ugly for our dear Uche in a bear real estate market. She could end up taking more loans just to pay off the interest, while same time burning all of her initial cash investments trying stop the effects of the borrowed capital.
It is safe to say that your goal determines whether (and how much) you can leverage . You have no business using leverage if you don’t have a sound investment strategy. It is also not advisable to take on debt as a strategy if you lack good financial habits, such as saving, budgeting, and making regular monthly payments for bills etc. Here are a list of things to consider before applying a leverage strategy to investing:
- Do not borrow money to spend, or to invest in stocks. Do what the wealthy do. Borrow money to create cash flow such as rental income
- Your risk level should be in line with what your trying to achieve. As such, consider using the lowest amount of risk to achieve your goals
- Be aware of interest rate risk. If the interest rate is favorable, assess what can make it change for the better or worse, as well as the effects it will have on your investment
- Use leverage as a strategy to get you to your goal. Be clear and be precise (Know your goals). Be clear about how using debt to finance your investment fits into your big picture. Once you do this, you may discover leverage isn’t required to achieve your investment goals
- Develop positive financial habits. Without these foundation money habits, taking on debt should not even be considered
In conclusion, applying leverage is not a beginners strategy. As such, have some money in the bank before you start borrowing, and get in the habit of regularly paying money out (good money habits). Last but not least, talk to a financial advisor to get a professional opinion about whether or not to apply a leverage strategy.
Key takeaway:
- Know yourself, know your goals: Cheap debt is using other people’s cheap money to build vast amounts of wealth. However, it is better to go with the lowest amount of risk at a consistent rate that at high risk with a high gain. It is advisable to grow at a level you can control
- Once you get clear about what you are trying to achieve, you may see there’s no need to apply a leverage strategy if your getting your goals
- Ask yourself: How does using a leverage strategy fit into my big picture?
Dig Deeper:
Video:” How debt can generate income” by Robert Kiyosaki. He popularised the idea of good debt and bad debt in his bestselling book “Rich Dad, Poor Dad”. Watch here