There’s a Chinese proverb that says, “Happy is the man with no sickness. Rich is a man with no debts.” And on a basic level, this is true. Debt, as most people know it, creates financial struggles, since borrowing money is essentially taking money away from your future self. But now we live in a world where debt is everywhere and is a major part of our economy. Virtually everyone uses debt. The difference is that some will use it to their benefit while others will misuse it.
For many, the concept that debt can be good can be hard to grasp because most of us only know one kind of debt or what many people call bad debt. These are debts that come out of your pocket with high interest like credit card debts, car loans, student loans that will take years or even decades to pay off.
In order to understand the positive side of debt, let’s understand how rich people make money with debt to build wealth versus how the average person uses debt. Most people see debt as a way to buy something they cannot afford to pay in cash, like a car or a house. And they will spend years or decades paying this debt to finally own what they bought.
For wealthy people, debt is just a tool that allows them to build something they can’t by themselves or help them accomplish things faster. To the wealthy, debt simply means more resources to grow and accomplish more.
1. Business Expansion and Growth
One way people use debt to make money is to use it to expand or speed up their business growth. Some companies use debt to invest in the expansion of their business, like hiring new employees or opening more locations. Companies can also create debt with other businesses to get their products or supplies on credit if they don’t have the resources to purchase them yet or choose to keep their money for other reasons.
For example, Steve Jobs made his first big sale for Apple using this strategy. He managed to sell 50 Apple 1 computers to a local computer store called the Bite Shop. But there was a problem. He didn’t have the parts he needed to make those computers, and he didn’t have the money to buy them either.
So, he went to a company that made computer parts and asked if he could get those parts on credit so he could build the computers. Since he had no credibility, he had to show the purchase order from the store in order to be able to get those parts on credit, which he did and completed the order, making Apple their first $25,000 in the 1970s, which in today’s money would be around $115,000.
Of course, if debt is used incorrectly, it can be detrimental to our finances. It is never recommended to use debt to start a business, especially if you are inexperienced. Many wealthy people spend time and resources understanding debt and how to use it.
2. Investment Leverage
The second way many wealthy people use debt to make money is by adding leverage to their portfolios. You see, most investors take their hard-earned money and put it into an investment portfolio to grow over time. But some take advantage of leverage, which basically means using debt in their investment portfolios to boost their earnings.
For example, let’s say that our friend Tom manages to invest $100,000 into an investment portfolio that produces a 10% yearly return. This means Tom will make a $10,000 return on investment. His friend Jerry also invests $100,000 in the same portfolio, but he adds a 35% leverage to his account. This means he has a total of $135,000 in his portfolio. $100,000 of his own money and $35,000 of debt.
With a market return of 10%, Jerry makes $13,500 instead of the $10,000 that Tom made. So Jerry’s return on investment goes up to 13.5% instead of the normal 10%.
This method, although able to produce higher returns, comes with higher risks. Let’s say that the market instead of increasing 10% goes down 10%. In this case, Tom will lose $10,000, but Jerry will lose over $13,000 since Jerry’s portfolio is technically bigger than Tom’s. Although it increases risk, leverage is widely used by sophisticated investors and hedge funds to increase long-term profits.
3. Short Selling Strategies
But there are other ways investors use debt to make money even if markets are going down. There’s a strategy that investors can use called shorting. With this strategy, institutions or individual investors don’t borrow money, but instead borrow stock from a brokerage firm.
For example, let’s say that an investor predicts that company X will go down in value. So, he borrows their stock worth $100. He now has debt not for $100, but for one share of company X. This investor immediately turns around and sells this share in the open market for $100. He now has $100 cash.
Lucky for him, it turns out his predictions were right. Company X had a big scandal for having mice in their kitchen and stocks fell 85% in a matter of days. This means shares are now worth $15. Well, our investor takes $15 from the $100 he got from selling the share in the first place and buys back the stock at a huge discount. He returns the stock he owes to the broker and keeps the $85 as profit minus a little interest for borrowing the stock.
This is how many investors and institutions like hedge funds make money on a falling market.
The Risks of Short Selling
Now, this method is extremely risky. You see, when you invest $100 in the stock market, the most you can lose is $100. And that is if the company you invested in goes to zero. But when you short a stock, your losses can be theoretically infinite since there’s no limit on how high a stock can go.
Take the recent GameStop debacle. Hedge funds shorted the stock heavily because it seemed like the company was going bankrupt. But retail investors didn’t take that too kindly and bought so much stock that they bumped up the price of the stock to astronomical levels. Within a year, the stock grew over 11,000% from its low point, making hedge funds who shorted the stock lose over $13 billion.
4. Real Estate Investment
Now, there are other more traditional ways people use debt to make money. Real estate is one of the most common ways the average person uses debt to grow their wealth. Real estate allows an investor to buy property even if they don’t have the money in hand to actually purchase it. This allows the investor to own a property and use it as a cash flowing asset. By borrowing money, they’re able to leverage a bigger asset. They can have other people pay their debts, build equity for them, and create positive cash flow.
Advanced Real Estate Strategies
For those savvy investors, they can use a few other strategies to expand their wealth. For example, let’s say that we buy this property for $300,000. We put $40,000 as a down payment and finance $260,000.
This property isn’t the nicest, but it’s in a great location and the local market is booming. So, we decide to spend an extra $10,000 to fix it up and make it look nice. Since this house is in a great location and the market is going up, we decided to get our property reassessed, and it is now worth $360,000.
With this new figure, we can go to our bank and refinance the property. We can add this additional $60,000 to our property’s equity or cash it out, essentially borrowing from our own assets to invest in another property that can make us more money and expand our wealth.
5. Strategic Financing Over Cash Purchases
When it comes to using debt to make money, some wealthy people prefer to finance some of the things that they want to buy. When interest rates are low, some investors prefer to borrow money. For example, if they want to buy a car for $50,000 and they can borrow that money at a 2% interest rate, some prefer to finance instead of paying with cash.
If they invest those $50,000 into the stock market and it gives them a return of 10% per year, they will be making more money back from their investments than they pay in interest.
If they finance for a 5-year period, they’ll end up paying a total of $52,583 including interest. But in those 5 years, the same $50,000 invested in the stock market would have grown to $80,525 at an average 10% return. A profit of almost $28,000 made with the help of debt.
Now, of course, this strategy works for those with high liquidity and those who have the ability to wait in case the market does not provide the returns they expect. This strategy does not work for those who don’t have this level of liquidity. Borrowing guarantees a loss, but investing does not guarantee a return.
6. Tax Avoidance Through Debt
One of the biggest ways wealthy people use debt is to avoid taxes. Wealthy people are quite astute when it comes to avoiding taxes. Normally, when you invest your money for retirement, you let your assets grow in value. And once you have enough money to retire, you begin slowly selling your assets or using your assets’ cash flow to pay for your lifestyle. But this also means that you will have to pay taxes on this money.
If you buy stocks or real estate properties and begin selling them when you retire, you will have to pay capital gains tax.
The Capital Gains Tax Problem
Let’s say that you worked very hard and now you have a $30 million real estate portfolio. You feel like you are ready to relax, retire, and enjoy the fruits of your labor. So, you sell a property for a $10 million profit to pay for your retirement. The sale of this property will trigger a $2.3 million capital gains tax to the federal government.
Then, since you live in the state of California, you will pay an additional $1.3 million in state taxes, meaning you will pay a total of $3,754,365 in capital gains tax. So, your $10 million profit is now $6.2 million. Nearly 40% of your profits went to taxes.
As an investor, losing 40% to taxes doesn’t sound like a great plan. So instead of selling the property, you decide to borrow those $10 million and use your $30 million real estate portfolio as collateral. Since debt is not income, it cannot be taxed. So you can enjoy your millions without having to pay capital gains tax.
The “Buy, Borrow, Die” Strategy
Now, since you borrowed money, you have to pay it back. This is when wealthy people use another tax loophole called the step-up basis to completely eliminate the need to pay taxes.
Normally, when you buy an asset that grows in value, you have to pay capital gains tax on the profits you made. But when you use a step-up basis and pass your assets to your kids, the asset’s starting value is adjusted to the current market value.
For example, if you bought a property for $100,000 and it is now worth $400,000, you had a $300,000 gain and you would pay taxes on that gain if you sold your asset. But when you pass your asset to your kid using the step-up basis, their starting value is $400,000. If they sold the property at that price, they would pay no taxes because there was no growth in value under their ownership. Technically, they didn’t make a profit.
This strategy is called “buy, borrow, and die.” Because to avoid paying taxes, you use your money to buy an asset. You then borrow against that asset to finance your lifestyle. And at the time of your death, you pass down your assets to your kids using the step-up basis. Then they can sell the assets with no tax consequences to pay off the debt.
The benefit of this strategy, other than avoiding taxes, is that since you did not sell your assets to pay for your lifestyle, the assets continue to grow in value. So, you end up with more money by borrowing rather than selling your assets.
The Fundamental Difference in Debt Philosophy
The key difference between how wealthy people and average people view debt lies in their fundamental understanding of what debt represents. For most people, debt is a burden – a way to acquire things they can’t afford that will cost them money over time through interest payments.
For wealthy individuals, debt is a strategic tool that can amplify returns, provide tax advantages, and accelerate wealth building when used properly. They understand that not all debt is created equal, and they carefully evaluate whether taking on debt will ultimately make them more money than the cost of borrowing.
The wealthy also typically have multiple income streams and substantial assets that provide security when using debt strategically. This allows them to take calculated risks that might be inappropriate for someone with limited financial resources or unstable income.
However, it’s crucial to understand that these strategies require significant financial knowledge, substantial assets, and often professional guidance. The risks involved can be substantial, and what works for wealthy individuals with diverse portfolios and multiple safety nets may not be appropriate for average investors.
The lesson here isn’t necessarily to rush out and take on more debt, but rather to understand that debt can be a powerful financial tool when used strategically by those who have the knowledge, resources, and risk tolerance to handle it effectively.