The essential function in all successful personal finance programs is saving. But while it is essential, saving alone may not be enough. The following article takes several shots at explaining how borrowing – which many people perceive as the opposite of saving – can “turbocharge” your finances.
There are two ways to accumulate wealth. One is to save, the other is to borrow. Of the two approaches, saving is easier to understand and execute. But borrowing (done right) may yield better returns.
Yeah, a bunch of financial “experts” just choked on their morning Starbucks in shock and outrage. You can almost hear the wailing: “When the average American consumer has over $16,000 in credit card debt, the median 401(k) balance is less than $30,000, and personal bankruptcies are coming off an all-time high, how could anyone responsibly recommend borrowing as a suitable financial strategy? People borrow enough already – they need to save, not borrow more!”
Those statements may be accurate, but that doesn’t change the first bullet point: Borrowing to accumulate wealth is a time-tested strategy; the history of almost all great fortunes includes borrowing.
So after cleaning up their spills, the experts should read on…
There is a difference between “good” borrowing and “bad” borrowing.
This difference is summarized in the following axiom:
Borrow to multiply assets,
not to satisfy consumption desires.
For most Americans, a good portion of their borrowing is for consumption – the “assets” they acquire through borrowing will be used up, not multiplied. Think of the reasons people have $16,000 balances on their credit cards:
1. They had an immediate need (kids’ school clothes, a medical situation, etc.); or
2. They wanted something now and didn’t have the money, but didn’t want to wait (a new outfit, a weekend vacation, an HD television). When you borrow because you can’t meet your present financial obligations, it’s “bad” borrowing. When you decide to borrow because you can’t handle delayed gratification, that’s bad borrowing, too.
Even some prevalent forms of “approved” debt are tainted by bad borrowing. A case can be made that both automobiles and personal residences qualify as assets – a car is an essential tool for earning an income, and most homes have the expectation of appreciation. But when you decide you will “step up to luxury” because a loan for a deluxe model is only $100 more each month, is that really “good” borrowing? If borrowing an additional $200,000 puts you in an exclusive subdivision, is it a wealth-building move or simply ego gratification? Borrowing more to buy a nicer car or a bigger home does not usually lead to a corresponding increase in net worth.
The key component in “good” borrowing is the financial leverage it creates.
Financial leverage refers to the use of debt to acquire additional assets. Borrowing allows you to control an asset – and benefit from its value – without paying the full price. Of course, in exchange for control you must also assume the obligation to repay the loan that made the leverage possible.
Here’s a very simple hypothetical example:
- On January 1, 2017, you place $100,000 in an accumulation account. In the upcoming year, the account generates a return of 8%. Thus, on December 31, 2017, the account will have ending value of $108,000.
- On January 1, 2017, you purchase a $500,000 commercial building by making a $100,000 down payment and borrowing $400,000. During the course of the year, the rent you receive from the tenants is just enough to cover your mortgage payments, taxes and maintenance expenses. The commercial property market is not booming, but stable. By December 31, 2017, values are up 2%, meaning your building is now worth $510,000. Along with a very small decrease in mortgage principal in the first year, your net equity is slightly over $110,000, an increase of more than $10,000.
Both transactions involve a $100,000 investment. But with leverage (made possible by borrowing), a 2% annual return from the real estate investment was better than the 8% generated by an accumulation/saving instrument – because the 2% was applied to $500,000 while the 8% accrued on $100,000. This is the power of leverage.
This simple illustration is not an apples-to-apples comparison that proves borrowing is better than saving. Saving and borrowing have different variables.
In the previous example, a deposit to an accumulation account typically does not require any day-to-day oversight by the account owner. If the instrument promises a guaranteed rate of return, investment risk is minimal as well, and many types of accounts can be liquidated on demand.
Not so for the building owner. Tenancy is not guaranteed; keeping the building full may require pricing decisions, marketing, and out-of-pocket remodeling costs. If rents are low, savings or other assets may have to be tapped to meet monthly mortgage obligations. And under most circumstances, real estate is not easy to liquidate. (On the other hand, positive cash flow from rents could further enhance returns from financial leverage.)
Real estate isn’t the only situation where financial leverage can generate greater prosperity. Borrowing to buy new equipment may increase production and profits. An investor may use leverage to buy a business, controlling all of its revenues with a small buy-in.
And the power of financial leverage isn’t just that a small outlay can control a larger asset. There is also a time element: saving has opportunity costs. How much profit is lost if a business waits five years in order to pay cash for equipment that could be producing today? Even when factoring the costs of borrowing, immediate gains may be greater than future returns after waiting to pay cash.
Which leads to another twist on the interplay between borrowing and saving…
To use good borrowing strategies, you may want to change the way you save.
Borrowing-for-assets strategies can be complex – both to execute and evaluate. But regardless of the details, there is no leverage opportunity for the borrower unless a lender believes its loans will be repaid. If you foresee the possibility of leveraging strategies in your financial plans, you should save accordingly.
Many borrowing transactions include down payments, lump sums that are transferred at the time of purchase. Where should these amounts be accumulated and held? Probably not in vehicles that incur withdrawal charges if liquidated before an arbitrary maturity date. Probably not in a qualified retirement plan (like an IRA or 401(k)), with tax penalties for early withdrawals, and restrictive loan provisions. And probably not in instruments whose value fluctuates frequently, or that require long holding periods to dampen that volatility.
In an ideal leverage scenario, a loan would be repaid from the revenues generated by the asset acquired; borrowing costs would be covered by profits. But buildings are sometimes not fully occupied, and business income doesn’t always flow in a steady stream. Because sustaining a leveraged investment may require additional funds, prudent borrowers maintain cash reserves.
Stashing some money in a safe, liquid saving vehicle may mean foregoing some opportunities for higher investment returns, but protecting a leveraged opportunity should be worth it. When borrowing results in foreclosures and repossessions, these are not profitable transactions.
Good borrowers have assets to multiply.
If borrowing for financial leverage is such a powerful idea, why doesn’t everyone do it? Why aren’t more people buying commercial real estate, expanding businesses, etc.? As was mentioned earlier, lenders make loans under the belief they will be repaid. It’s sort of a rich-get-richer situation, but the best borrowing candidates are the ones who already have assets. In other words, they’ve done some saving first.
It is appropriate to note that borrowing for prosperity can work for those who don’t have financial assets. Some people have what might be characterized as intangible assets: They have an idea, a skill, or product that could become profitable through expansion or duplication. Instead of making five widgets a week, a new factory could produce 50 – at a lower cost. Or one store could become a chain of six, multiplying sales while achieving economies of scale.
But if you haven’t accumulated financial assets to buffer the uncertainties that come from attempting to leverage prosperity, borrowing on such a narrow margin for financial error can be ruinous. Accumulated savings are insurance against leveraging hiccups.