3 Reasons Why Borrowing is the Ultimate Wealth Builder Tool Than Saving
The power of wealth is not about how much you have in your bank account but is determined by your ability to borrow.
When I was young, my dad told me many get rich by building wealth instead of earning a high salary.
"Income is only a tool to fuel your investment; your main focus and job should always be your investment."
I was in 8th grade and was puzzled, "If the investment is what I need to focus on, why am I learning everything in school to earn a high salary?"
He elaborated that a high salary could not replicate the wealth you can accumulate through compound interest and appreciation in investment leveraging a high salary.
"However, " he said, "You cannot fund your investment if you don't have a high salary because a high salary can give you more opportunity to borrow and fund your investment. Therefore, this is the first step in the wealth-building roadmap."
Too many of us focus too much on saving accounts and savings on our investments. Often, those are the same people that have a fixed income.
However, wealth is accumulated faster, not by how much money you have in your bank account, but by your ability to borrow.
Here's why.
It Is Much Faster to Start a Business With Borrowing.
If you understand that you can use your credit to borrow that additional capital from the bank, you can get that 100K capital to launch your business way faster than saving up to that amount.
Yuval Harari talks about money in his book Sapiens. Capitalism has changed the concept of money to represent and convert things that only exist in the present into an opportunity for future growth. Money can represent an opportunity for growth to transform ideas into something that can represent goods in the future. This way of thinking - a form of exchange representing imaginary goods, goods that do not exist in the present, helps humans finance new enterprises. Usually, this type of money is called "credit," and it is an assumption that our future resources are sure to be far more abundant than our present resources.
The one thing that I learned is that most wealth builders around the world are made from borrowing rather than from saving.
Businesses and startups use equity to borrow money to obtain the marketplace and wealth they want to achieve quickly. Real estate investors borrow their properties' appreciation to quickly obtain a new investment opportunity.
Suppose you need to attack the opportunity that's in front of you. In that case, the ability to borrow will give you a competitive advantage compared to everyone else who requires time to accumulate that money.
Borrowing is Tax-Free
Anything that you spend from your savings is required to be taxed. You will realize that the more you earn, the more money goes to the IRS.
However, you also see many wealthy people living happily, paying near zero taxes to the IRS.
When I asked my CPA how I could avoid paying over 40% tax, he told me there was no way around it because you are salaried.
"To get taxed less, you can try to put as much of your money into an asset and borrow that asset later instead of paying yourself now."
For appreciation incomes, the IRS wants the profit from your asset appreciation.
To avoid or delay the hefty tax obligation regulating the capital gains incurred, they borrow against their wealth, use the proceeds to pay for their expenses, and reinvest in new ventures. In this way, they keep their tax bills low, continue to benefit from their invested assets' appreciation, and increase their overall net worth with the additional investments made with the loan proceeds.
How do the rich use borrowing to their advantage?
Edward McCaffery, a professor at the University of Southern California, first thought about the idea a few years into his teaching career and realized how certain tax law doctrines could benefit the wealthy. For instance, the Realization requirement means you only pay taxes on an asset once it produces cash.
This term helps the wealthy to build up their assets tax-free.
You must think, "sooner or later, you're going to have to sell."
That is not the case. As long as someone is wealthy enough to live on a percentage of their assets, they never have to sell. Instead, they can borrow those assets at an interest rate much lower than the rate the assets will appreciate over time and spend it.
Unlike regular salaries or wages that most people use to pay for their living expenses, borrowing isn't taxed, so they face a relatively low tax bill.
Borrowing Uses the Power of Leverage
Leverage is a technique used by investors to use debt to increase the potential return on investment.
Instead of saving the full amount to invest in rental properties, you can put little to no money down and use debt to help you buy the rental property.
There are a couple of ways to access leverage: a mortgage with a standard 20% or less down payment that gets you 100% of the house you want to live in—using your home's equity as leverage to borrow more capital and buy more properties, etc.
Human capital is the most widely used form of leverage: getting an education with student loans. A student loan is an investment in a valuable asset - your human capital. In other words, they help you work on yourself and build your skills. When you invest in education by taking out student loans, you unlock the potential to pay off your loan in the future with potential earnings that will likely be worth more later.
There is a catch. You must have a good credit score to use the power of leverage. Thus, having good credit is paramount in increasing your options for investment opportunities.
Let me illustrate the power of leverage.
Consider that the common real estate purchase requires a 20% down payment. That's $100K on a $500K property. By putting down only 20% of the money and borrowing the rest, the buyer uses a relatively small percentage of their funds to make the purchase. That's why real estate investors often refer to the remaining 80% of the purchase price as other people's money.
Let's assume the property appreciates at a rate of 5% per year. It means your net worth grows to $525K in 12 months. In some places in the country, $25K in 12 months is a considerable amount of growth.
Imagine if you decide not to use the power of leverage to purchase a 100K house - you use all cash. Assume that the property also appreciates by 5% each year. That appreciation will equal $5000 over 12 months - versus 25K for the more expensive property.
Now, a picture of 5% gain every year for 20 years. Do you notice how impactful the power of leverage is on your net worth? You are using the same amount of money to invest in properties, but with the power of leverage, you can significantly increase your ROI in the long run.
Let that sink in.
Conclusion
We were taught that borrowing has a negative connotation; even Dave Ramsey said it is best to pay for everything with cash. However, most people will only be able to substantially grow their net worth in their lifetime if they use the power of borrowing. Borrowing can help you attack the opportunity in front of you much faster than anyone else. Moreover, learn from the rich by borrowing to pay fewer taxes. Lastly, borrowing is not evil when you understand the power of leverage. Building wealth is all about being able to utilize the power of leverage.