If you can borrow money, you can use leverage to increase the return on your investments. This is possible because you can own and control more property with less of your own money.
Borrowing Options: Benefits and Dangers of Borrowing
1. Borrowing Options: Benefits and Dangers of Borrowing
What are the benefits of borrowing money?
Successful borrowing can help you create a positive credit history
Succesfullyborrowing and paying off your loans as agreed canhelp you establishagood credit
rating and make obtaining additional credit possible. Even if you do not typcially use credit
often, it is good to have the ability to do so in the event of an emergency.
Leverage can be used to increase the return on your investments
If you can borrow money, you can use leverage to increase the return on your investments.
This is possiblebecause you can own and control more property with less ofyour own money.
The following illustrates how you can increase the return on your investment using leverage:
Example(s): Hal had $50,000 that he wanted to invest in real estate. He found a house that
cost $150,000. He convinced Frank and Bob to invest $50,000 each in the same house. They
purchased the house and each owned one-third. The value of the house increased to
$180,000 and was sold. Frank, Hal, and Bob shared a $30,000 profit. Each realized a $10,000
gain, or a 20 percent return, on their investment.
Example(s): Hal, decided to invest in more real estate. However, this time he decided to use
leverage to increase the return on his investment. He made a $50,000 down payment on a
$150,000 house and took out a mortgage for $100,000. By borrowing in this manner, he was
able to own and control the entire asset, rather than just one-third. When the house
increased in value to $180,000, he sold it, paid off the mortgage, and realized a $30,000 gain,
or a 60 percent return, on his investment.
The example is simplified and does not take into consideration taxes, interest, or rental
income, but it illustrates the notion that by using leverage, you can control more assets using
less of your own money.
Caution: The problem with leverage is that it can work both ways. Assume that the two
parcels of real estate in the previous example dropped in value to $120,000. In the first
transaction, Hal would have lost $10,000, for a 20 percent loss on his investment. In the
leveraged transaction, Hal would have lost $30,000, for a 60 percent loss on his investment.
2. Credit cards are a convenient way to make purchases
Credit cards are a convenient way to make everyday purchases. Some credit cards even offer
incentive points for making certain types of purchases (e.g., groceries and gas). Keep in mind
that if you do use a credit card on a regular basis, you’ll want to be sure to pay off the card in
full every month.
Interest on some forms of borrowing is tax deductible
If you have equity in your home and the ability to borrow, you may be able to benefit from
tax-deductible interest. If you have major expenses or other high-interest debt, you can take
out a home equity loan or line of credit and pay off or refinance the debt. In most cases, the
interest on such loans is tax deductible, making the cost of funds cheaper.
What are the dangers of borrowing money?
Overspending is a risk when credit is readily available
When credit cards and home equity lines of credit are readily available,itis easyto overspend,
leaving your credit cards and equity lines tapped out.
Borrowing can increase the cost of goods purchased
If you make purchases on credit and pay them off over time, you end up paying the original
purchase price plus afee (interest) for the extension of credit. This means the cost of acquiring
the goods is greater. In other words, it isn’t really a sale if you buy that suit at 10 percent off
using an 18 percent credit card.
Of course, total interest paid would be less if you made larger monthly payments and paid off
the balance earlier. However, many consumers underestimate their ability to do so and end
up increasing the cost of everything they purchase by paying excessive interest.
Caution:In addition to the excessiveinterest,there are annual fees and late payment charges
that can further increase the cost of borrowing.
Insolvency results from excessive borrowing
Insolvency is commonly defined in two ways. Insolvency is the condition of being unable to
pay your debts as they come due. Insolvency is also defined as the condition of having more
3. liabilities than assets. If you own a home, a car, and a house full of furniture, you may think
you have plenty of assets. However, if you borrowed to acquire your belongings, you may be
closer to insolvency than you think.
Many consumers carry high credit card balances or have mortgaged the equity in their homes
to pay college,medical, or other expenses.Given this situation and no other significantassets,
you can easily find yourself insolvent and unable to pay your current bills, while interest, late
fees, and penalties accrue daily. Always evaluate your financial situation prior to taking on
new debt.ler and is independent of Raymond James Financial Services.