WarrenBuffet, the world’s successful investor,
has famously said that in pursuit of wealth we should always try to
avoid borrowing. But for the average person, is this realistic?
Without borrowing, how could many of us afford to buy a house, a car
and other assets with our own cash while also ensuring that we have
enough savings to cover any eventualities such as illness, or to ensure
that we have enough cash saved for our retirement? For most of us, debt
is a necessary tool to help us acquire basic assets.
Michael Lee-Chin, in an interview with Forbes magazine, has
posited that one of the many ways billionaires acquire wealth is to “use
other people’s money”. It so happens that getting a loan from a
financial institution is essentially a way of using other people’s
money. The key to borrowing is to make sure you do so responsibly by
actively employing another one of Warren Buffet’s investment tenets:
“Never lose money.”
If you are going to take a loan, I find that it helps to use the
following guidelines to determine whether this loan will actually be
beneficial in helping to achieve your long-term goals, including wealth
generation and planning for retirement:
1) What is the purpose?
If you are going to borrow, you must think seriously about what the
loan is being used for. Ideally, if you are paying interest on borrowed
funds, it should be in pursuit of acquiring an appreciating asset. In
other words, funds you borrow should be used to purchase or invest in
something that will increase in value over time.
If, for some reason, your loan is being used to buy a depreciating
asset such as a car, you should consider the long-term value that it
will bring to your life. Will it enable you to get a better job, improve
or increase your income opportunities, or improve your standard of
living in a quantifiable way?
2) Earn more interest than you pay
Now that you have ensured that you are borrowing for the right reasons,
you need to ensure that your loan makes financial sense in the big
picture of your long-term financial goals. When you borrow, you pay
interest to your creditor. Which means that even though you are well on
your way to owning a valuable asset, you will be losing cash while
making your loan payments to your creditor. The cash you will lose while
repaying a loan will be significantly higher than the original cost of
the asset itself. That is, you will inevitably pay your creditor a lot
more than you originally borrowed.
Therefore, when borrowing you should:
*Ensure that after your loan payments you will still have disposable income for saving or investment.
*Find investment options that will give you a higher return on your
investment than it will cost you to borrow. For example, if you can
borrow at 10 per cent but invest at 11 per cent or more, then you will
earn net income that will help you to efficiently build wealth over
3) Earn positive cash flow
Another option for building wealth with debt is to ensure that your
debt helps you to earn positive cash flow. That means you should be
earning more cash from your assets or investments than you are paying
out to the bank.
The method to achieve this is much more simple, but may be slightly
more elusive for some borrowers. This option involves borrowing to
purchase an asset that will generate cash flow such as rental property,
investment in a company, or purchase of bonds or dividend paying stock.
This is one of the central investment tenets of the book Rich Dad Poor Dad
by Robert Kiyosaki. This philosophy is simple: Only borrow if it will
help you to earn more money. For many of us this is challenging, as the
biggest loans we have are usually for the car we drive to work and the
house we live in – neither of which tends to generate cash. If, however,
you are able to leverage those assets to generate cash which can then
be reinvested, you would be well on your way to building sustainable
BE CAREFUL OF UNSECURED DEBT
With interest rates in Jamaica being the lowest they have been in many
years, and competition between banks at an all-time high, it is easier
than ever to get credit. Banks are basically begging you to borrow. They
entice you by lowering fees and offering you unsecured loans and credit
cards, pre-approved of course, so that way you don’t have to go through
all the usual hassle of trying to get a loan.
As consumers this is great for us, because that means we have power in the market.
On the other hand, we must be careful of how we accept these offers and
how we use borrowed funds. Unsecured debt and credit cards carry the
highest interest rates in the market. They should not be taken lightly
or used frivolously. Unsecured debt must always be used in accordance
with rules 1, 2 and 3 above.
Needless to say, there are several other considerations to make when
borrowing or investing that will be discussed in future columns. For
most of us, borrowing is inevitable. However, if we try to consistently
apply the rules above, then borrowing can be a great tool for building
wealth instead of being a financial burden.
Claudja Williams works as a consumer advocate in the financial sector. The views expressed are her own.