Debt used in appropriate levels, at the right time, in your asset-building stage, can provide a tremendous boost to your net nest egg assets at retirement. The premise is quite simple: borrowing money for investment purposes (purchasing things like property or shares) allows you to purchase more or bigger investments than you would have otherwise been able to purchase on your own without the borrowed money.
The bigger purchase, growing at whatever growth rate your investment grows at, results in more dollars in your back pocket. Let me explain with some numbers.
Say you have two investments – $100,000 and $500,000 – and both investments had the same 10 per cent return. The bigger $500,000 investment would earn more ($50,000) than the smaller $100,000 investment did ($10,000) in the first year.
Now if the difference between the $100,000 investment and the $500,000 was $400,000 you borrowed from the bank, you could (ignoring taxes for simplicity) sell your investment for $550,000, repay the bank $400,000 and keep the $150,000: your original $100,000 investment + your $50,000 return. You’d have some interest to pay on the borrowed money but, even allowing for that, you’re far better off in this example than you would have been only investing $100,000.
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Now, in reality, the bank will want to be paid some interest for the money you borrowed, so that should be factored into the return, as should capital gains taxes on the sale of your asset, but you get the idea. Borrowing money for investment purposes can help you earn greater returns than you otherwise may have been able to earn on your own.
While borrowing money can magnify your gains if things go well and you earn some good returns, it will also magnify your losses if things go badly and you have negative returns.
In this scenario, the return on the same investments is negative 10 per cent, instead of positive 10 per cent in the first example.
When you’re just investing your own $100,000, the value of your investment drops by 10 per cent down to $90,000. But, if you had borrowed $400,000 to make a $500,000 investment that then drops by 10 per cent, the bank still wants their $400,000 back, which only leaves you with $50,000. Plus, you still need to pay the bank’s interest bill too. Not a great outcome, but this highlights one of the major risks you need to consider when you use borrowed money for investing.