Edge-ucation / Market Commentary

How Debt Helps the Rich Get Richer

  • Edge Editorial Team

    At Edge Investments, we make investing in small cap stocks enjoyable and edge-ucational. We are here to teach you about investing, keep you up to date on news, and help connect you with companies that you may have a desire to invest in.

    View all posts

Chances are, at some point, you learned about debt in the form of credit cards car loans, or mortgages. 

There are many diverse types of debt, and each has its advantages and disadvantages 

The concept of borrowing money instinctually sounds like it’s something that most people would generally want to avoid. Not to mention “interest” is taxed on to virtually all debt instruments, which means that you have to pay extra to be granted the privilege of borrowing. 

But what if we told you debt can be a savvy investment mechanism? Wealthy people all around the world have built massive empires (and subsequently, massive net worths) by leveraging the elusive art of debt; today you’re going to learn how you can do the same. 

What is Debt? 

Debt comes in many ways, shapes, and forms. The common principle defines debt as borrowed money. Not only does that money have to be paid back in full by the borrower, but they will likely also incur a percentage of interest in addition to the principal (the original amount of money you borrowed) amount. Interest is the lenders’ incentive for giving up their capital. 

If a lender loans $100,000 for a 4-year term and wishes to charge 20% total interest, they expect the principal $100,000 back plus $20,000 in interest by the end of the 4 years. 

Interest can be paid monthly, yearly, or however often as dictated on the terms of the debt. Monthly interest payments are the most popular as it creates a form of steady cash-flow for the lending party. 

Although, debt has its constraints – it is not handed out to just anybody. Since the lender is putting themself at risk of not receiving their money back, they subject the borrower to a risk assessment equation. The borrower must be qualified under the debt requirements and there usually needs to be a form of collateral to consider the loan.  

Collateral refers to assets that can be seized by the lender should the borrower fail to make repayments. While not every loan requires collateral, the ones that do often have lower interest rates because the collateral provides a safety net for the lender, in the event of a default (ie, an inability to pay). 

How Much Interest Do You Pay on Debt? 

As a borrower, the least as humanly possible… hopefully. As a lender, the most as legally and morally appropriate… hopefully. 

All jokes aside, the interest rate on debt is more than a negotiation. 

Lenders typically identify their desired return and investigate a borrower’s financial health diligently before determining what interest rate they will require and whether the borrower qualifies for the loan in the first place. 

Did you know? While interest is often paid monthly, rates are almost always quoted annually. For example, a 5% interest rate on a $2.4 million loan would yield an interest income of $10,000 per month, based on ($2,400,000 x 5% = $120,000), divided by 12 months equaling $10,000 monthly. 

The standard principle for lending money is that the riskier the loan, the more interest is charged. When banks give out mortgages, the lender inspects income statements, credit score, past/current mortgages, net assets, and more, to determine the level of risk. It tends to be a scrutinous process. 

A typical loan gives the borrower access to a lump sum of capital to use for purchases or business needs. This debt gets paid off in monthly installments, with each payment often consisting of both principal and interest. 

Car Loans 

These are self-explanatory. They are used to finance the purchase of a vehicle. While there are last-resort car loan businesses that offer exorbitantly high interest rates to underqualified borrowers, traditional car loans charge interest based on credit score, length of term, type of vehicle and a range of other factors. According to a study by ValuePenguin (although the rates can vary), the average car loan term in the U.S. is 5.27% annual interest on a 60-month loan. 

Mortgages 

One of the most common types of debt: mortgages.  

Mortgages are loans (typically) given out by banks and credit unions that lend someone the portion of a real estate purchase that they cannot (or don’t wish to) cover with the down payment. Mortgages charge a monthly repayment consisting of a combination of principal and interest. Interest rates for mortgages can vary greatly depending on the individual; however, they tend to stay at or near a country’s prime rate for qualified borrowers. 

Did you know: prime rate is the rate that banks charge their preferred borrowers (ie, those with the highest credit ratings). This rate is determined by a country’s government (via the central bank) and is a measure used to influence consumer spending/borrowing and control inflation. 

Line of Credit 

Not unlike a credit card, lines of credit provide a revolving line of capital that can be accessed anytime. The interest on a line of credit is only charged on the amounts withdrawn from the total available amount. Lines of credit are given out to financial healthy people with a good credit score, a profitable business, and/or a considerable amount of equity in real estate. The interest rates on lines of credit tend to be below those of a credit card. 

A key advantage of a line of credit over a traditional loan is that you don’t need to borrow and pay interest on a large lump sum at once; you can simply use what you need, when you need it, how you need it. 

Debt Financing 

Debt financing comes in many forms, and bonds are one of them. When a business doesn’t want to further dilute their shareholders’ ownership (which would happen if they initiated an equity financing), they may elect to issue debt securities. This would require monthly payments from cash flow to cover the interest, and the principal may be included in these payments depending on the type of debt security. 

Maintaining a proper balance of debt financing and equity financing is how you obtain a healthy weighted average cost of capital (WACC). 

There are many more examples of debt vehicles, with varying degrees of complexity, but these are some of the most common. Now, it’s time to look at how one can properly grow wealth through debt 

Until next time,

-Edge

  • Edge Editorial Team

    At Edge Investments, we make investing in small cap stocks enjoyable and edge-ucational. We are here to teach you about investing, keep you up to date on news, and help connect you with companies that you may have a desire to invest in.

    View all posts

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