5 Rules of Thumb to Become a Savvy Borrower

Devil spawn or road to easy riches?

Debt is one of the most controversial tools in finance. It’s been demonized and lionized, depending on who’s talking. Both lender and borrower take on risk, and both can lose their shirts in the process. An economic nuclear winter will kill both sides, but in general, the more leverage, the greater the risk.

“The harder they come, the harder they fall,” to quote Jimmy Cliff.

Debt, like a hammer, can build or destroy, depending on how it’s wielded.

Here’s how to use debt to create wealth.

1. Buy an asset that throws off more cash than it costs you in interest. 

You don’t want to borrow money to buy something that sucks up even more of your cash than just making the interest payments.

OK, fine. 

You can finance a house whose carrying costs (property taxes, insurance, maintenance, interest) you can justify because you’d have to pay rent otherwise. You’ll build equity albeit, slowly. But it’s worth doing a rent vs. buy analysis before taking on a 30-year mortgage.

Remember, whatever you buy with borrowed funds needs to earn its keep if you want to sleep at night.

2. Don’t count on capital appreciation to save your ass. 

If you’re paying interest with today’s dollars hoping that the thing you bought will be worth more tomorrow, you’re speculating.

Not that there’s anything wrong with that, IF you know what you’re doing.

Just don’t kid yourself if you’re borrowing something hoping the thing you buy will be worth more later (especially if it doesn’t throw off income).

What you need to be able to answer: In the best case, how much do I stand to make? In the worst case, will I lose everything? What’s the most likely case? Have I identified the risks? Can I afford to be wrong?

3. Don’t borrow to buy a depreciating asset unless you have to.

Your principal is set by the acquisition price. Your proceeds are set by the liquidation value. 

If the car you just drove off the lot is now worth 20% less, and you financed 90% of the value, you are now underwater. You owe 10% more than the car is worth.

Focus on the loan to liquidation value, not what your monthly payments will be.

4. Match the debt investment horizon to the asset you’re buying.

Don’t fund a short-term asset with long-term paper. If you plan to own it for 6 months, don’t borrow against it for 10 years. The longer dated the loan, the higher the interest rate. (Unless the yield curve is inverted, but that’s another story.) 

Don’t borrow short-term for a long-term obligation. If there’s a credit crunch you won’t be able to borrow to meet your obligation. 

Make sure your time horizons are not like mismatched socks.

5. Beware of volatility in either the collateral or the interest rate.

Use floating rate debt only if you understand the risks.  Your adjustable rate mortgage, which was no problem at 2% interest, might bankrupt you at 7%. To add insult to injury, your house will be worth less because rates are higher.

It’s easier to manage risk (and cash flows) when your interest payments are predictable. 

If you borrow a fixed amount against collateral whose value is volatile, you might end up in trouble. For example, borrowing money to buy stocks can be risky. If there’s a huge decline in the share prices, you’ll have to put up more money or have the positions sold out from under you. If that happens, you may have little left to show for it.

Leverage is great on the way up, and deadly on the way down.

(There are some tax strategies using margin against large stock holdings deployed by zillionaires, that make sense, but the key is the amount of leverage. The more volatile the asset, the smaller the loan-to-value should be.)

Keep these 5 things in mind, and leverage will be your friend.