Credit & Debt: Trick or Treat?

An old phrase has always made me stop and ponder: “debt is a tool.” Just like a saw or a hammer, the phrase suggests, debt can hurt or help.

Some businesspeople swear by debt – “leverage,” they call it. In a dream scenario, the idea is that a business loan can create the “runway” (time and resources) you need to start a business that will eventually pay off mightily.

When times are good and the entrepreneur gets lucky, the concept works wonderfully. Here’s an example. A real estate investor has $100,000 in their bank account. They use that as 20% down to purchase a home for $500,000. Their monthly mortgage payments are $3,000, which they cover with $3,000 monthly rent from tenants. In 30 years, let’s say the house has doubled in value. With the mortgage paid off, they sell the house for $1,000,000. The new math? Their $100,000 turned into $1,000,000. (Yes, that leaves out lots of details, like the property taxes and repairs they paid for on top of the mortgage payment.) But you get the idea – if they hadn’t used a loan in the equation, the math would have been less impressive. They would have had to save up $500,000 (yikes!), after which they would have doubled their money, rather than multiplied it by ten.

But consider the other side of the coin. If the economy slows, that $500,000 home could decrease in value, like many did in 2008.

Suddenly, you might owe the bank more than the home is worth. Worse yet, lower home prices will mean that you might not be able to cover your mortgage payments with rent. Suddenly, you’re given three rough choices: pay out of pocket each month to keep the home, sell it at a loss, or stop payment and lose everything you invested to the bank. If you’d bought it outright with cash, you’d be safe, waiting out the day when value returned.

The most difficult piece of this debate is how much is unpredictable. The economy goes up and down based on lots of factors – none of them within your control. Often, the difference between an entrepreneur who looked smart by using debt “as a tool” and one who looks foolish for doing so? Timing. Put another way, luck.

So we return to the question at hand: is debt a trick or a treat? The truth is you may not know the answer until the very end.