U.S. citizens have $15 trillion in household debt. Within this astronomical number, there are both good and bad loans. When people borrow and spend the money on something that won’t appreciate in value (often with no other choice), they’ve taken on bad debt. But when it’s used to invest in something that appreciates more than its borrowing costs, debt can be a good thing.
Businesses use debt all the time. Apple (NASDAQ: AAPL) has over $100 billion in debt, which it reinvests in new products and generate profits. With good credit, you can utilize good debt for yourself, too, the same way a business does. You simply need a secured loan with predictable and manageable cash flows. By borrowing at a low rate (3%) and getting a higher rate on your investments (8%), you can earn an additional 5% on your money. Borrowing to invest can enable you to earn more money, without needing a higher paycheck.
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We are living in a unique environment with increasing inflation, even as borrowing rates remain near historic lows. People can get mortgages for under 3%, and lock in those rates for over 10 years! By using stable assets as collateral, such as your home or stock portfolio, you can often get a loan at an attractive rate and invest the proceeds for a healthy return. Before taking a loan as part of your investing strategy, just remember a few key ground rules.
1. Evaluate your debt based on monthly cash flows.
You never want your debt payments to go over 36% of your income. Beyond that inflection point, banks have decided that borrowers start becoming unreliable about making payments, and banks use that figure to decide whether to give people loans. For an average family earning $5,500 per month, that 36% threshold limits their debt payments to $2,000 — a sum that encompasses mortgages, auto loans, credit card interest, etc.
If you are spending more than 36% on debt-specific payments, then you shouldn’t use debt for investments. Instead, continue to pay off your existing debt until you’re far enough on the other side of your inflection point to safely take on more.
2. Find a low rate opportunity
With all their accompanying jargon and promotional rates, loans can be very confusing. Here’s what to look for.
For long-term loans of five-plus years, you should look for fixed rates, because they are transparent and predictable. Anything under 4% is a good rate, since you can expect to earn twice that in the long run from the stock market. The lower your rate, the better. Because of compound interest, rate is the most important factor — the lower the rate you’re charged, the more of your gains you can keep for yourself, and the bigger those gains can grow over time.
All things equal, a fixed rate is best since it has less risk. Unfortunately, you may not be able to find a fixed rate for any loan term less than five years. This makes a floating rate loan your best choice, since they often have lower rates, at least at first. But borrowers should keep in mind that rates are expected to rise in 2023.
Any floating-rate loan you accept should start under 3.5%, a half-point lower to account for a potential rate hike predicted by the Federal Reserve over the next three years. Floating-rate loans generally start with a more attractive rate, but if rates go up, so will your interest payments. Because rising rates have been slow or temporary over the last 20 years, your loan will likely stay relatively cheap over the next three to five years. However, you’ll lose the guarantee that you’ll know how much you owe for next month’s payment.
You can start searching for personal loans here. And if you can’t find a low rate but have good credit, you can try to negotiate a better deal with the bank. If you’re a responsible borrower, they want your business!
3. Borrow a modest amount and invest the proceeds
Imagine two investors, Ashley and Esther. They each have no debt and a $100,000 stock portfolio fully invested in the S&P 500. They just got a hard-earned promotion and a raise. After more spending, they’ll both have $200 left over every month, and they’re deciding what to do with it.
Ashley invests $200/month in the S&P 500, earning 8% per year. Nothing wrong with that, and she earns $9,000 more than someone who puts it all in a checking account after 10 years ($33,000 vs $24,000).
Esther, having seen the power of investing to build her portfolio, decides to use debt to amplify her returns. Instead of directly investing, she sets aside the extra $200/month for future loan payments, keeping her debt well below 36% of her income.
With a good credit score, she obtains a $20,000 loan for 10 years at a 3% fixed rate. This will cost her $193/month to pay every month for 10 years, at which point she’ll be debt-free again if she chooses.
Then she invests the loan into the S&P 500 Vanguard ETF (NYSEMKT: VOO) and earns 8% returns over the next decade, ending with $43,000 and no debt.
Esther was able to invest $20,000 up front and enjoyed compound returns, growing it to $43,000 after a decade. Because she received a big sum and invested that in her first year, she could use her extra $200/month to pay down her loan.
As a result, Esther has $9,000 more than Ashley in her account, just from a $20,000 loan. Rather than just investing her extra money, she found a strategy that took little risk, and earned solid rewards.
4. Always make sure you can pay it off
Your total debt level shouldn’t go too high compared to your assets. Remember how Apple has $100 billion in debt? Well, that isn’t so high when you consider that it’s valued at $2.4 trillion.
Esther’s example works because she could pay it off over time. With a $193/month payment, she knew that the loan would be done in 10 years. She paid interest and principal, enabling her to make sure that her loan balance went down, not up.
If you are worried that the market is too expensive to implement this strategy today, consider this: Over the last 30 years, the stock market has averaged 10.7% returns per year. Over a 10-year period in the last century, it beats a 3% interest rate hurdle over 90% of the time. By borrowing at low rates and investing for the long-term, you can earn additional money as well.
Debt doesn’t have to be scary. It should go hand-in-hand with your investments. By finding reliable low rate loans, you can fuel your investments with responsible debt to accomplish your goals.
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David Smith owns shares of Vanguard S&P 500 ETF. The Motley Fool owns shares of and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
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