Debt sure has a bad reputation these days. Every time I pick up a newspaper, all I see are articles about the “sovereign debt crisis.” When I turn on the television, I’m bombarded with commercials from companies offering to help people with their “debt troubles.” I can understand why many people today see debt as a disease, something to avoid like the plague. That’s too bad, because I think debt is one of the greatest inventions of all time, and probably the best tool we have for building wealth.
There’s no question: Many individuals and even some large governments today are struggling with debt. However, debt is not responsible for all the misery, the individuals who used the debt are at fault. Debt is not something that is good or bad in itself. How debt is used determines whether an outcome is good or bad. Similarly, fire is not good or bad in itself, but how fire is used determines whether an outcome is good (i.e. a campfire) or bad (i.e. a forest fire). Debt and fire also have another thing in common: When used incorrectly, you can get badly burned.[pullquote align=”left”]Debt is one of the greatest inventions of all time, and probably the best tool we have for building wealth.[/pullquote]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 experts classify 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 considered good debt. Borrowed money used to buy something that depreciates (like a car, TV, or vacation) is typically considered bad debt.
The Wrong Way to Use Debt in Building Wealth
Much of today’s debt problems started back in 2005. At that time, people around the world were using cheap debt to buy real estate at ever increasing prices. Many people thought real estate prices always go up, so the debt they were taking on was “good debt.” However, what most people didn’t see at the time was the housing bubble that was developing. Real estate assets were bought at incredibly inflated prices during the peak of the bubble. When the bubble finally burst and housing prices came crashing down, many people were stuck with large amounts of debt and houses worth a fraction of what was paid for them.
There is a lot of blame to go around after the real estate bubble. Some of the many guilty parties include dishonest lenders, morally corrupt Wall Street bankers, incompetent regulators, and delusional buyers. In the end, as with all financial calamities, the underlying emotion driving all the madness was greed.
Using Debt to Build Wealth
So understandably, many people today see debt as pure evil. However, the ugliness of the real estate collapse should not mask the many benefits of debt. For example, debt is used to finance many public projects like hospitals, schools, roads and bridges. Debt also gives businesses and entrepreneurs the necessary capital to develop new products, expand new markets and grow the overall economy. Without debt as a tool to fund new ideas, innovation would grind to a stop.
Debt is a great tool to move money from those who have it to those who need it. Almost 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 and had to use credit from a supplier to build the first computers they sold. Apple is now one of the most valuable companies on the planet. There are countless other stories of individuals building successful businesses and creating tremendous amounts of wealth beginning with a small loan.
A New Opportunity for Building Wealth?
Today’s situation may be giving way to a new opportunity for creating wealth. Interest rates are still at historic low levels, stock markets are stagnant, and some companies appear to be cheap judging from their fundamentals. This may explain the slight 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 opportunity may be emerging for individual investors as well. Many quality blue chip companies have come down in price, giving individuals an opportunity to “buy low.”
Of course nobody can tell the future. The sovereign debt crisis could get a lot worse, the stock market could fall further, interest rates could rise significantly, or a new crisis 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 are always dangers to using debt (as the real estate bubble clearly shows), so anyone considering borrowing to invest should consult their professional advisor. However, using debt to buy quality assets when prices are cheap greatly 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 significant wealth, you need to have debt ready and at your disposal.