A strategic use of debt may help your clients achieve their short- and long-term financial goals.
Americans are no strangers to debt. The average debt balance held by U. S. consumers is $101,915. 1 Depending on how and why they’re borrowing, however, debt can be useful.
People who deal with money and building wealth often give debt a bad name. After all, having a lot of credit card or payday loan debt with high interest rates can really hurt your finances. On the other hand, debt can be a powerful way to get rich if you know how to use “good debt,” which means borrowing money to buy investments and assets that will grow in value over time or bring in money.
In this guide, we’ll explore time-tested strategies the ultra-wealthy use to employ leverage and debt to their advantage. While improper debt use can lead to financial disaster, wielded wisely, it can significantly amplify returns and accelerate your wealth-building goals.
What is Good Debt vs Bad Debt?
Not all debt is created equal There are two main types
Good debt is when you borrow money to buy assets that will go up in value or to make money that is higher than the cost of the debt. Business loans, student loans, and mortgages on investment properties are some examples. This type of strategic borrowing builds wealth.
Bad debt is when you borrow money for things that won’t help you in the long run. In this group are credit cards, payday loans, and auto loans. They waste money by making interest payments and don’t give you any chances to make money back.
The wealthy concentrate on assuming good debt for assets that have potential to gain value and produce income over time. They avoid bad debt for consuming and depreciating purchases that add no value.
3 Powerful Ways the Wealthy Use Debt to Get Rich
1. Leveraged Investing
Savvy investors use leverage to multiply returns on their capital. They don’t buy assets outright; instead, they borrow money at low interest rates to get control of more assets and make more money. Here are two common examples:
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Margin investing – Investors can borrow up to 50% from their brokerage to buy more stocks. This allows them to magnify their upside if stocks appreciate.
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Leveraged ETFs – These exchange-traded funds use built-in leverage to amplify market index returns by 200-300%. This turbocharges gains compared to investing the same amount in regular index funds.
The key is that the returns from the leveraged assets consistently exceed the cost of borrowing. When executed prudently, this strategy generates wealth rapidly.
2. The Buy, Borrow, Die Strategy
This clever technique involves:
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Buy: Purchasing assets expected to appreciate significantly over decades like real estate, businesses, art, etc.
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Borrow: Taking loans against the value of assets instead of selling when liquidity is needed. Interest expenses are tax deductible.
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Die: Passing assets onto heirs tax-free upon death to avoid capital gains taxes. Heirs can then sell the assets to repay loans if needed.
This strategy lets you access an asset’s value while avoiding taxes on capital gains, interest, and estates. The ultra-wealthy employ this to build wealth they can pass on.
3. Leveraged Buyouts (LBOs)
Private equity firms and wealthy investors use LBOs to acquire companies using a small amount of their own capital and large debt financing. A typical LBO transaction involves:
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Buying majority control of a target company’s equity with around 10-30% cash.
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Funding the remaining 70-90% of the purchase price through loans secured by the acquired company’s assets or future cash flows.
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Servicing the debt load with the cash flows of the acquired company.
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Selling the company years later for a profit.
Since little capital is required upfront, LBOs offer the potential for outsized returns through the power of leverage. The ultra-wealthy use LBOs to snap up income-producing companies and amplify their wealth.
Wielding the Power and Risks of Leverage
Used strategically, debt provides tremendous leverage to accelerate wealth-building. With risky leverage, comes potential rewards but also amplified dangers:
Upside: Magnified returns on capital and assets acquired
Downside: Increased losses if investments decline in value
Costs: Interest, fees, and expenses associated with borrowing
Liquidity: Leveraged assets may be difficult to sell quickly
The wealthy mitigate these risks by using conservative loan amounts, smart asset selection, ample cash reserves, and expert financial advice. For individuals seeking accelerated wealth-building, leverage can be profitable when applied prudently. But reckless borrowing often leads to financial disaster.
Rather than always being detrimental, debt strategically utilized can be a tool for getting rich faster. The wealthy employ leverage to purchase income-producing assets, fund growth, and turbocharge returns. When harnessed wisely, good debt that generates appreciating assets and cash flow can compound wealth rapidly. But bad debt that merely funds consumption results in interest payments without returns. By understanding good debt vs bad debt and using leverage judiciously, you too can employ it as a wealth accelerator. But ensure you have the risk tolerance, liquidity, and financial acumen first.
Good debt may help your clients avoid bad outcomes
Lucky tells the story of a client who owed a lot of money in taxes and paid it on April 15, long before June, when he was supposed to get the money. The client could have sold off some assets in his portfolio to pay the tax bill, but that would have required reconstructing his portfolio afterward, not to mention paying transaction costs and potentially more taxes. Instead, the client decided to take out a loan to pay the tax bill and then repaid the loan in June. “Avoiding disruption in their portfolio is an example of using debt effectively,” explains Luckman.
Your client may want to consider using income generated from diversified investments to pay down bad debts. When they look at how much debt they have, they might decide that it makes the most sense to sell something to quickly pay off their debts. This is where their personal debt tolerance comes in.
Good debt may help your clients accomplish their objectives
Given the link between college degrees and higher earnings over the course of a person’s career, student loans are likely the most common example of good debt. 3 But that’s just the start. “Good debt can help borrowers accomplish an objective or help them avoid a bad outcome,” says Luckman.
When it comes to accomplishing your clients objectives, consider another common example of good debt: taking out a mortgage on a new house. For most people, it’s not possible to pay for a house outright. However, even if you were able to pay for it in one large payment, there are benefits to taking on debt for a home. Paying down a mortgage results in equity in a home as well as potential tax advantages. Plus, if your client knows they’ll be able to make their monthly payment, there is the additional benefit of improving their credit score by making the payments consistently.
Depending on their circumstances and risk tolerance, leveraged investing can be another good debt strategy. Say they’re investing $100 with an expected 10% rate of return. If they invested their own money, they would earn $10. But if they were to invest half their money and borrow for the other half, they could earn more, if the interest on the loan is less than 10%. In this example, says Luckman, “they leveraged their return.”
Another potentially effective debt strategy involves using a loan to diversify their investment portfolio, especially for certain affluent individuals who hold a concentrated stock position in a single company. They can borrow against that concentrated position to buy stocks in other companies, making for a more balanced long-term investment strategy. An added benefit of borrowing against a concentrated stock position to diversify their portfolio is that they may defer paying the capital gains tax they would incur if they sold the concentrated stock.
How Rich People Use Debt to Build Wealth (…and YOU can, too!)
FAQ
How do people use debt to get rich?
In corporate finance, people use debt to acquire cash flow-producing assets and leverage the tax code (i. e. , depreciation) to maximize profits. In this article, you’ll learn how to differentiate between good and bad debt, explore examples of each, and discover how the ultra-rich use debt to get richer (mainly through Leveraged Buyouts ).
How to use debt to build wealth?
Leveraging equities is another way to use debt to build wealth. Leverage can be used in trading index funds and stocks, where instead of buying one share of the S&P500, now trading around $2,100, you can invest just $210, and trade the rest on margin. If the index goes down $210, you are wiped out and have lost all your money.
How can leveraged debt help you build wealth?
Remember that leveraged debt is not just a loan. It’s a lever (or catapult!) to help you build more wealth. A home mortgage, investment properties, low-interest loans, and business loans are all good ways to use debt in a smart way. Whether they fit with your current income and financial goals is unique.
How to get rich from debt?
You can improve your finances and build long-term wealth by taking out loans to buy real estate that will go up in value, consolidate high-interest debts to make cash flow better, use high-yield savings accounts, or borrow to buy businesses that will make you money.
How to pay off $30,000 in debt in 1 year?
Three easy steps helped this 34-year-old get rid of $30,000 in credit card debt in one year. Step 1: Look over the land. Step 2: Limit and leverage. Step 3: Automate your minimum payments. Step 4: Yes, you must pay extra and often. Step 5: Evaluate the plan often. Step 6: Ramp-up when you ‘re ready.
Can you be profitable with debt?
You profit off of debt if you have mortgages on real estate that are cash flow positive via rental income and depreciation, your salary is exceeding inflation or you have a business that grants you numerous tax write-offs. All other debt, car note, student debt, cc debt, HELOCS are all liabilities and are not assets.
Can a rich person be in debt?
You’ll see many wealthy people use loans like this just to fund their lifestyle. They have bills that they have to pay day in and day out, so using debt for this is a huge advantage for them in a few ways.