The smartest business people have always recognized the value of debt in building wealth. The idea that all debt leads to financial ruin can often be wrong.
To take a closer look at when debt can be good, here are five cases to consider:
1) When you can use borrowed funds to earn a greater after-tax return than the after-tax cost of borrowing. For example, if the debt costs you about 4% annually after tax deductibles to borrow, and you can make after-tax returns of greater than 4% then you will grow youth wealth by borrowing and using those funds. Two Yale professors, Ian Ayres and Barry Nalebuff recently found out that in analysis going back to 1871, if younger investors used margin to increase their investment power, on average, they could retire six years earlier and still achieve the same retirement lifestyle.
2) When you don’t have the cash to buy something today, but are very confident that you will be able to pay for it over time, it can be good to take on debt. The most common case of this is buying a house. Without debt, very few people could ever buy their first house.
3) When there is a time-limited opportunity to buy something of value. A good example of this might be an ability to buy private company shares, invest in a company matching program, or make an RSP contribution in a year when your income is high.
4) When there is a window of time to do something special. For example, if an older person dreams of taking a big trip somewhere expensive but waiting on better cash flow, they should consider getting a line of credit and taking the trip anyway. Health reasons might detract future possibilities.
5) When you believe that future credit will be hard to come by, it is often good to arrange for credit or debt today. An example might be if you are currently an employee but are planning on starting a new company or becoming self-employed. The time to get debt is before you change your employment.
For all the scenarios above however, it is important to have a strong payback plan.
What is important to remember is if you arrange your debt options through careful planning, for a specific purpose and based on your ability, carrying some debt might be helpful for you.