“Better to go to bed hungry than to wake up in debt” Unknown

“Debt is the worst poverty” Thomas Fuller

“A lot of people go into debt just to keep up with those who already are” Unknown

Debt needs to hire an image consultant in my opinion. Google the word debt and you get a number of quotes, including those above. Debt is considered a bad thing by many personal finance commentators and amateur financial planners. The view is that debt is bad, and it can bring you ruin. It is a four letter word and is best avoided.

I grew up getting this advice from family, friends and anyone that felt the need to give me advice. Stay away from debt! Neither a lender nor a borrower be! Debt is bad! And so forth. One did not need to look far for anecdotal evidence of the devastation that debt could inflict on a borrower. The statistics are arguably worse today with almost 50% of borrowers close on 3 months behind on debt repayments. The number of people going into debt review has risen sharply over the past few years, as it tends to do when interest rates rise. The global economy is considered to be in something of a debt crisis at the moment. This is more evidence to stay away from debt apparently.

I regret simply taking the advice of well-meaning adults to stay away from debt. The reason is that I ended up waiting too long to buy my first property. I was a bit too cautious in my earlier years as a result of wanting to pay cash for everything. What I needed to have done was think a little deeper about the issue of debt. Why would something considered universally bad continue to exist for decades? Why are banks some of the largest businesses in world if a big part of what they are offering is bad? Could debt have any redeeming features that I should consider? But first, why does debt have such a bad rap?

Why debt is bad

The reason that debt is bad is not because of debt per se, but rather because of how people use debt. A 2009 survey by TNS Research showed that the reason people borrowed money was largely to fund consumption (to buy groceries, clothing, lights and water, furniture, and pay for school fees). The problem with consumption is that you use up whatever it is you borrowed for. At the end of the day you have debt, and nothing to show for that debt. This type of debt is also expensive debt, so you end up paying a lot more than you borrowed. Because of the consumptive nature of the items funded by debt, what starts to happen is that people develop a habit of funding consumption using debt. So people get used to the idea of paying for groceries, petrol, clothing, etc with debt. By the time they wake up to the problem they are often in too deep, and they have nothing to show for that debt except old clothes and an expanding waistline. Habits are a very powerful thing, especially over the long term.

How can debt make you wealthy?

It is easy really, it just requires understanding, patience and discipline. Debt attracts interest at a rate, usually linked to the prime rate. If you borrow money at say 10% but then use it to purchase an asset that grows at 15% then your wealth increases as the difference in returns compounds over time. If there is a problem at some point in the future, simply sell the asset and settle the debt (yes, easier said than done, but certainly can be done).

Consider the case of the Phuthuma Nathi (PN) share scheme. In 2006 PN bought shares in MultiChoice SA (MCSA) at R50 a share. Investors paid R10 a share, and PN borrowed the remaining R40. Over the years PN used the dividends from MCSA to service the debt. By 2014 PN settled the debt in full.

An investment into MCSA would have grown from R50 to around R300 (500%), and the investor would have made around R100 (100%) in dividends (estimate). That is a stunning return in its own right, but nowhere near the returns achieved by PN shareholders. PN shareholders earned more than R53 a share in dividends and the value of their PN shares is currently R130 a share. PN shareholders made a total return of 33% p.a. compared to MCSA shareholders that earned approximately 23% p.a. over the same period. The use of debt resulted in an enhanced return in the order of 10% per annum in this instance. That is massive and an outlier, but certainly shows the potential. R10,000 invested in PN grew to around R183,000 over the past 10 years, while R10,000 in MCSA would have grown to around R70,000 over the same period.

Many property investors can attest to the power of debt in enhancing returns. However, get it wrong, and you can find yourself in trouble. Shareholders in African Bank’s two public deals lost everything as a result of a debt funded investment in a bad asset. It is important that debt is not used to speculate, and there really is no need to speculate. Rather consider a basket of quality high yielding shares if you wish to attempt to replicate the PN case study. I would also say wait until there is a big pull back in the market (over 20% drop) before attempting such a strategy.

How to make use of debt to enhance returns

An important starting point is to build up a good credit record so that the banks will lend you money. Be prepared to fund initial borrowings from income, until you have built up a decent reserve. Start out small, try different approaches, and be disciplined in terms of understanding the risks to your investments. Finally, be patient, much of the wealth creation comes from compounding the extra return, and compounding works effectively over time.

The point of this blog is to show case another side of debt that is not well understood by many, not to promote the use of debt for investing. Until people have a more balanced view of debt, and its potential, debt is likely to continue to be demonised and only be used by the wealthy to enhance their already massive fortunes.

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