American citizens have $ 15 trillion in household debt. In this astronomical number, there are both good and bad loans. When people borrow and spend money on something that won’t increase in value (often with no other choice), they incur bad debt. But when used to invest in something that appreciates more than its borrowing costs, debt can be a good thing.
Businesses use debt all the time. Apple (NASDAQ: AAPL) has over $ 100 billion in debt, which it is reinvesting in new products and generating profits. With good credit, you can also use good debt on yourself, the same way a business can. You just need a secured loan with predictable and manageable cash flow. By borrowing at a low rate (3%) and getting a higher rate on your investments (8%), you can earn an additional 5% on your money. Borrowing to invest can help you earn more money, without the need for a higher salary.
We live in a unique environment with rising inflation, even though borrowing rates remain close to their all-time lows. People can get mortgages under 3% and lock in those rates for over 10 years! By using stable assets as collateral, like your house or your stock portfolio, you can often get a loan at an attractive rate and invest the proceeds for a healthy return. Before taking out a loan as part of your investment strategy, just remember a few key ground rules.
1. Evaluate your debt based on monthly cash flow.
You never want your debt repayments to exceed 36% of your income. Beyond this inflection point, banks have decided that borrowers are starting to become unreliable in making payments, and banks are using this figure to decide whether or not to grant loans to people. For the average family earning $ 5,500 per month, that 36% threshold limits their debt repayment to $ 2,000 – an amount that includes mortgages, car loans, credit card interest, and so on.
If you are spending more than 36% on specific debt payments, you shouldn’t be using the debt for investments. Instead, keep paying off your existing debt until you’re far enough beyond your inflection point to safely take on more.
2. Find an opportunity at low rates
With all of their jargon and promotional rates, loans can be very confusing. Here’s what to look for.
For long term loans of five years and more, you should look for fixed rates because they are transparent and predictable. Anything below 4% is a good rate because you can expect to earn double the stock market in the long run. The lower your rate, the better. Due to compound interest, the rate is the most important factor – the lower the rate you are charged, the more you can keep your earnings to yourself and the more those earnings can grow over time.
All other things being equal, a fixed rate is preferable because it carries less risk. Unfortunately, you may not be able to find a fixed rate for a loan that is less than five years old. This makes an adjustable rate loan your best bet as they often have lower rates, at least initially. But borrowers should keep in mind that rates are expected to rise in 2023.
Any variable rate loan you accept should start below 3.5%, half a point lower to account for a potential rate hike the Federal Reserve is planning over the next three years. Variable rate loans usually start with a more attractive rate, but if the rates go up, your interest payments will go up as well. Since the rate hike has been slow or temporary over the past 20 years, your loan will likely stay relatively cheap for the next three to five years. However, you will lose the guarantee that you will know how much you owe for next month’s payment.
You can start looking for personal loans here. And if you can’t find a low rate but have good credit, you can try to negotiate a better deal with the bank. If you are a responsible borrower, they want your business!
3. Borrow a small amount and invest the proceeds
Imagine two investors, Ashley and Esther. They each have no debt and a $ 100,000 stock portfolio fully invested in the S&P 500. They just got a hard-earned promotion and raise. After spending more, they will both have $ 200 left each month, and they decide what to do with it.
Ashley invests $ 200 / month in the S&P 500, earning 8% per annum. Nothing wrong with that, and she earns $ 9,000 more than someone who puts everything in a checking account after 10 years ($ 33,000 versus $ 24,000).
Esther, having seen the power of investing to build her portfolio, decides to use debt to amplify her returns. Instead of investing directly, she sets aside the additional $ 200 / month for future loan repayments, which keeps her debt well below 36% of her income.
With a good credit rating, she obtains a 10-year loan of $ 20,000 at a fixed rate of 3%. It will cost her $ 193 / month to pay monthly for 10 years, after which she will be debt free again if she wishes.
Then, she invests the loan in the S&P 500 Vanguard ETF (NYSEMKT: VOO) and earns an 8% return over the next decade, ending with $ 43,000 and no debt.
Esther was able to invest $ 20,000 up front and enjoyed compound returns, raising them to $ 43,000 after a decade. Because she received a large sum and invested it in her first year, she was able to use her extra $ 200 per month to pay off her loan.
As a result, Esther has $ 9,000 more than Ashley on her account, just from a loan of $ 20,000. Rather than just investing her extra cash, she found a strategy that took little risk and earned solid rewards.
4. Always make sure you can pay it back
Your total debt level should not be too high compared to your assets. Remember how Apple got $ 100 billion in debt? Well, it’s not that high considering it’s valued at $ 2.4 trillion.
Esther’s example works because she could pay it back over time. With a payment of $ 193 / month, she knew the loan would be made in 10 years. She paid interest and principal, allowing him to ensure that the balance of his loan goes down and not.
If you’re worried that the market is costing too much to implement this strategy today, consider this: Over the past 30 years, the stock market has generated an average of 10.7% returns per year. Over a 10 year period in the last century, it beats a 3% interest rate hurdle more than 90% of the time. By borrowing at low rates and investing for the long term, you can also earn extra money.
Debt shouldn’t be scary. It should go hand in hand with your investments. By finding reliable loans at low rates, you can fuel your investments with responsible debt to meet your goals.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.