Why you need debt to build wealth
Even if you hate being in debt, it’s impossible to live without it. So why not accept the fact that you are likely be in debt throughout your career. There will be student loans and a home mortgage at the beginning, practice purchase loans at mid-career and perhaps bank loans for your children’s university education later on. Even during retirement, some dentists may choose to borrow money against their life insurance policy or take out a home equity line of credit for tax free money to supplement their retirement income.
But even though we all go through it, being in debt still has negative connotations as evidenced by the phrase “debt burden.” Many people might perceive a 65-year-old dentist with a million-dollar loan as a poor money manager. But rather than viewing debt as an obstacle to a worry-free retirement, it makes more sense to reframe our views and consider it an aid.
You cannot grow wealthy through savings alone, no matter how much you earn. Borrowing is important because it allows you to purchase an asset now. If you borrow $1 million today to purchase a home, your cost is locked in. If the home increases in value to $1.5 million in five years, your equity has increased by $500,000. Had you delayed the purchase by 5 years, you would have had to save about $170,000 of your pre-tax income each year to realize the same amount.
So, it makes sense to purchase your dream home as soon as you qualify for a mortgage rather than wait until your student loan is paid off or house prices drop.
Using debt to lock in the cost of an asset such as your principal residence is just one way borrowed money can create financial security. Another way to boost investment returns through debt is using it to borrow money to invest, called leveraging. Here is an illustration.
You put $100,000 of your own money into a balanced portfolio generating a 6 per cent return. The annual income is $6,000.
You borrow $400,000 at 3.5 per cent and invest it in the same portfolio earning 6 per cent.
Your total portfolio income is: $500,000 at 6 per cent = $30,000
Less loan interest: $400,000 at 3.5 per cent = ($14,000)
Total return on your investment of $100,000 = $16,000 which is equal to a return of 16 per cent.
Leveraging allows you to generate a greater return without purchasing riskier investments.
Why is now a good time to consider leveraging?
- Interest rates are still reasonably low. Most dentists have access to loans at the bank prime, a rate usually reserved for large businesses.
- Dentists enjoy a steady practice income.
- Most investment portfolios produce mediocre returns. And because many dentists are unwilling to purchase riskier investments yielding higher returns, many are left frustrated in their efforts to save enough for a decent retirement. Leveraging helps boost investment returns while maintaining the same level of risk.
A word of caution before jumping in. Leveraging can be a double-edged sword that magnifies both gains and losses. It can make you rich, but it can turn you into a pauper just as easily. Make sure you understand the risks and proceed with caution.