Debt is a weapon that should be handled with care. You can either use it to build out your passive income streams, protect your income streams and lifestyle, or destroy your wealth. There are many options for borrowing money so we will give a brief overview here for now.
What is debt?
Debt is when you borrow money from someone else. Debt can have many different names depending on what type of debt it is and how it is obtained.
The person who is borrowing funds is typically called the borrower or the debtor. On the other side of the transaction or contract is the lender or the creditor who lends out money to others.
The goal of the borrower is to pay for something now with money they don’t have and to pay back the lender in an agreed upon timeframe. The goal of the lender is to be compensated for lending their money by charging the borrower interest which will be paid back to the lender along with the original amount borrowed.
How do I get debt?
Typically, the lender will need some type of guarantee that they will get their money back. Your personal finances, credit score, and assets can all be used to assess the risk of lending you money.
Collateral, or something of value, is used as a guarantee if the borrower can’t pay back the lender. This provides the lender some reassurance that in a worst case scenario, they can recoup their losses by obtaining something valuable to sell and get their money back. This is also known as leverage where you use your assets to give you a access to more money.
Debt, or leverage, usually comes in 2 flavors: a lump sum loan (think of a mortgage) with a payback time frame or a line of credit that can be used a little at a time (think of a credit card) and you are charged based on the used balance.
Let’s go over the different types of assets you may have and the associated debt that can be obtained!
Lenders may consider how much money you make in order to lend you money. Credit cards and other unsecured loans may look at your personal finances to determine if you would be a good fit as an investment for them.
If this is the case, then your debt to income ratio will be crucial to obtaining funds. This ratio is derived from the amount of debt obligations you already are paying divided by your income.
An example would be you are paying $2,500 a month toward your student loans, credit card bills, and home mortgage or rent while your personal monthly income is $5,000. Your ratio would be 50% ($2,500/$5,000), thus the lender will figure out what a safe amount is to give you so you have a higher likelihood of paying back the loan.
The lower the ratio, the higher the chances of you not only obtaining a loan, but also getting a lot more money to work with. If the ratio is too high, then you know you either need to increase income, decrease debt expenses, or do both.
Cars, Boats, Art, Antiques, Jewelry, etc.
There are things you may own that have some value to them. You can use this to your advantage if your debt to income ratio may not be the best at the moment and you need money.
In most cases, the things you’d like to use as collateral will need to be owned out right and free from any other debt obligations. The lender may have some specific requirements for these assets (minimum value, age of the asset, ownership certificates, etc.) all in an attempt to ensure their investment in you is secure.
Commodities (Precious Metals, Livestock, Food)
This doesn’t mean you can use your golden sports trophy, your golden retriever, or your famous golden chocolate bacon to get a loan.
You can invest in gold, silver, cattle, sheep, grain, corn, etc and use those investments as collateral for a loan.
The idea is the same, the lender is just trying to have something they can obtain the value of if you don’t pay them back.
Traditional Investments (Cash, CDs, Bonds, Stocks)
The lower the risk of the investment, the more you may be able to get as a portfolio loan or line of credit. Either the amount could more or the interest rate you are charged could be lower than personal loans or credit cards.
Quick Note: This is different than a margin account. Margin accounts allow you to use the value of the assets in your account as collateral for a line of credit to either buy more assets (typically stocks for short-term trading tactics) within the account or take out a loan. Either way the interest rate is typically variable.
A drawback to using traditional investments is if you pledge a riskier asset that fluctuates in value then you may be asked to make up the difference between what was pledged and any shortfall or downturn in pricing. While you may get turned down by banks for assets in your IRA, the provider of your employer plan (401k, 403b, etc.) may give you the option take out a loan based on the value of your account.
Taking out a loan against your employer plan gives you access to those funds without having to pay taxes, penalties, or disrupting the compounding affect of your investments. One of the benefits here is that the plan may provide that the interest that is paid back is actually paid into the account you have. This way you may be able to pay a little more into the plan if one of your goals is to live off of the withdrawals one day.
Real Estate and Business
These assets are probably some of the first that come to mind when thinking about taking out a loan. Commonly people take out mortgage loans in order to buy a house, but as the home equity increases you can use it as collateral to take out additional loans and lines of credit.
The same goes for a business. Sometimes it makes more since to take out a loan based on the value of the assets and income from the business in order to pay for projects or expand operations.
Since these assets are common and can be considered relatively stable, the loan terms are some of the most favorable with interest rates falling well below personal loans and credit cards. The more real estate and businesses you own, the more debt you can take out.
Whole Life Insurance
While you can build up the cash value of your policy and receive passive dividends to add to the cash balance, you can also request a loan. The policy provider will use the cash value to determine how much to give you (i.e. 50-70% of cash value).
Depending on the provider, the payback may be flexible. You might choose to never pay it back especially if you have a large balance and could use the funds until the end of your life. This would provide you with tax-free funds (because it’s debt) and the remaining balance being paid off by the cash value upon your demise.
How does this help me grow my passive income?
Leveraging your assets has multiple benefits for the passive income investor. These benefits come in two forms: growing your wealth or protecting your wealth (which in turn allows it more time to grow).
Leverage for growth
Real estate investors understand this and use the acquisition of one property to buy more. One path is after purchasing a home for themselves, they can get a line of credit based on the equity of their home to fund downpayments or outright purchases on other properties.
From there, investors either build up the value so they can opt to take out a mortgage to pay themselves back and keep the property as a rental for passive income purposes or sell the property for more than the purchase price. The latter option would be considered more active than passive but hopefully you get the point.
What if you don’t have a house or don’t want a house? The above list should hopefully give you some ideas of other places you have already stored wealth to grow your portfolio.
You could use half of your own funds and half of a portfolio loan to acquire a passive income business you want to BUILD. This reduces the payments since it’s not 100% leveraged and gives you instant equity.
You could get a loan by using your art, jewelry, or even cryptocurrency as collateral and loan out your money to those who are willing to pay a higher rate of interest and collect the passive interest payments while paying off the bank loan and keeping the difference.
You could leverage a bank account or CD. Maybe you want to use those funds for something else but the stock market is crashing and there’s a dividend stock who hasn’t cut it’s dividends that you’ve been buying little by little. Let’s say that with the price reduction, the dividend yield is now much higher than the loan interest and you’d rather buy a huge lump sum while the price is low. You combine your personal funds with the loan and make big buy. You now have a new income stream that you can use to payback the loan and instead of investing small amounts into stock, you can put that money towards paying back the loan sooner. Once the loan is gone, the income will remain.
You could secure a position in a promising private investment that needs capital now by leveraging your whole life insurance policy cash value or employer plan to come up with short-term funds if it’s not a good time sell your taxable account investments. This lets you take advantage of opportunities quicker and reduces excuses for not having the funds (provided you are okay with potentially losing the investment and paying the debt back another way).
Although these are best case scenarios, the opportunity should be clear. Leverage allows you to increase returns, acquire more assets, and reduces hurdles other potential investors face.
Leverage for protection
Sometimes, life comes at you fast.
Your car breaks down, the sewer pipe or roof of your house gives out, a loved one falls ill and insurance won’t cover any of it.
You retire and then the stock and bond markets drop which dramatically affects your portfolio income if you were banking on living off the capital gains.
You or a significant other loses a job and your household income is cut in half.
You find out you need more health care than you planned but have a strong desire to leave an inheritance for your loved ones.
These are all real possibilities. Having a high net worth (more assets than liabilities) or lots of passive income is not just an ego thing. One of the biggest benefits is that you have options other people don’t have.
Most people will take out a personal loan or put their expenses on a credit card. The interest rates on these products can shoot past the national average rates and soar to over 20%. Once again, these are considered unsecured since there is not an asset behind the loan. Once you secure the loan with an asset, then the rates become more reasonable.
You can draw on your home equity line of credit to cover your personal expenses while you look for a new job at say 8% instead of 29% on the credit card.
You can leverage your whole life insurance policy or take out a reverse mortgage on your home and live off the loan proceeds until the end of your life and not have to worry about taxes or having to use up assets earmarked for inheritance. This way you can still leave your other assets to your family members upon your passing so that they can continue to grow the assets for their usage.
You can take out a loan against your stock portfolio and consolidate your bills and debts. If your credit score is important to you, this could help you keep it intact until you decide to either sell the stocks once they’ve increased in value to pay off the loan or figure out how to increase your income to make the loan payments.
Risks & Considerations
We will end where we began, debt is a weapon. You can either provide for yourself with it or hurt yourself and others. Asset values can drop, especially if you have no control over them. Financial institutions are in the business of making money and keeping money (as you should be as well) so if what you promised them falls in value, you will need to make up the difference.
What if you bought a business with debt and the business fails, are you willing to sell other assets to pay off the debt, find work that will make the payments, or start a new business to pay for debts of the failed one?
What if you bought a speculative stock with debt based on your home equity and the company goes bankrupt or management changes? Can you either make the payments until your bet pays off or figure out a way to pay off the loan?
While leverage can be used to grow and protect your portfolio, you should be aware of the repercussions if things don’t go according to plan. Using leverage is high risk with potentially high rewards. Even business professionals get it wrong at times.
While it is admirable to go “all-in” on your ideas, you should be realistic about the risks and be able to live with the worst case scenario. If you can live with that, then you can move forward with your decision.