When debt is good

Posted on 28. Sep, 2010 by in News

Ted Rechtshaffen ,Globe and Mail Update, Published Friday, Sep. 24, 2010 11:16AM EDT

There is a great fear sweeping the land. It is a belief that all debt is a scourge to be wiped out.

The truth is that the smartest businesspeople recognize the value of debt in building wealth.

If there was ever a time to consider adding debt, now is one of the best times in history, as it has never been this cheap.

Today you can borrow money at 2.9 per cent fixed for three years. With tax deductibility, that can bring the cost down to as low as 1.6 per cent.

To help you understand when debt is good, here are five cases to consider:

1) When you can use borrowed funds to earn a greater after-tax return than the after-tax cost of borrowing. As in the three-year example above, if you can invest in something that will pay you more than 1.6 per cent after tax per year over three years, then you will grow your wealth by borrowing and using those funds.

2) When you don’t have the cash to buy something today, but are very confident that you will be able to pay for it over time, it can be good to take on debt. The most common case of this is buying a house. Without debt, very few people could ever buy their first house.

3) When there is a time-limited opportunity to buy something of value. A good example of this might be an ability to buy private company shares, invest in a company matching program, or make an RSP contribution in a year when your income is high.

4) When there is a window of time to do something special. A great example is an older person who dreams of taking a big trip somewhere expensive. They may not have the health to take the trip five years from now, but may not have the cash flow to do it today. Often this occurs because their wealth is tied up in a house. It can be a great time to borrow from a line of credit to take a trip, and it can be paid back a few years later when the house is sold.

5) When you believe that future credit will be hard to come by, it is often good to arrange for credit or debt today. An example might be if you are currently an employee but are planning on starting a new company or becoming self-employed. The time to get debt is before you change your employment.

As a final point, two Yale professors, Ian Ayres and Barry Nalebuff, recently produced a paper called “Life-cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk.” It says that in analysis going back to 1871, if younger investors used margin to increase their investment power, on average, they could retire six years earlier and still achieve the same retirement lifestyle.

Just imagine if the study only looked at borrowing costs when they were 1.6 per cent after tax!

Tags: , ,

Comments are closed.