Not all debt is considered “bad”. In fact, it’s possible to use debt to build wealth over the long term.

On financial markets, the concept of leverage – or using borrowed money to increase your return on investment – is widely accepted.

Applied to personal finances, debt can also be a useful tool. Below, we discuss:

• good versus bad debt
• use of debt on financial markets
• using debt to build personal wealth
• what to be careful about when taking on debt.

‘Efficient’ vs. ‘inefficient’ debt

Differentiating between the good (or efficient) debt and bad (or inefficient) debt relies on a few factors.

These factors include the interest rate on the debt, what the loan is being used for and your personal financial position. Ask yourself, how likely are you to be able to pay back the debt?

Essentially, debt is only good if it will eventually improve your net worth.

For example, a home loan is considered efficient debt when it’s paid back consistently. In the end, you have a paid-off home that increases your personal wealth. Property also appreciates over time as an asset.

A retail store account is inefficient debt. This is because shop accounts carry high interest rates.

There is no wealth growth. Many items bought on store credit will have been consumed by the time you’ve repaid the debt.

Use of debt (or leverage) on financial markets

Typically, the purpose of using leverage in financial transactions is to get greater returns than would otherwise be possible. This involves accepting the risk of greater potential losses.

Margin investing, for example, allows you to buy a higher amount of stock than you actually have the money for. As the stock price increases, you pay back the difference and keep any profit.

With leveraged ETFs, you can amplify returns by going long or short on specific indexes, bonds, commodities or sectors. However, as much as leveraged ETFs can magnify gains, they can do the same for losses.

Hedge funds are known for generating abnormal returns using leverage. They can lever up to 10 times their total assets. But if the fund manager’s thesis is wrong, the hedge fund can lose the capital of all investors.

Short selling is borrowing shares from an investor and selling them just before the shares decline. This requires precise timing. It’s possible to lose even more than the initial investment.

With Forex trading, an investor can control large blocks of currencies with a small amount of money. Currency trading can make investors a lot of money very quickly, but it can also clean you out just as quickly if you “bet” the wrong way.

Ways to use debt to build wealth in personal finances

Of course, there are more everyday ways to use debt to build wealth, such as investing in assets, and improving your personal earning potential.

Funding business growth

Investing in assets that will help your business grow can build wealth for the future. For example, borrowing money to buy machinery or equipment that will improve or expand your output will increase the business’ profits in the long term.

Investing in assets that grow in value over time

Borrowing money to buy property and investing in improvements that will boost a property’s value are prime examples of good debt. The interest rate is still relatively low, making now a good time to secure a home loan.

Examples of other assets that usually increase in value over time include land, fine art, luxury watches, gold, collectible wines, classic cars and real estate investment trusts (REITs).

Investing in education

Using a student loan or personal loan to invest in education will give you bankable skills. You can apply for higher-paying positions that will help you build wealth. To maximise this investment, look for skills that are in high demand in South Africa.

What to be careful about when using debt to build wealth in South Africa

Managing your debt is part of investing wisely. Make sure you’re debt-savvy before you take out a loan or credit.

Some ways to avoid bad or risky debt situations include:

• never skip or make late payments
• research fees and other charges
• find out the interest rate beforehand and if it’s fixed
• make sure you can afford the repayments if the interest rate goes up
• talk to your creditors if you’re having financial difficulties
• make sure you have credit, disability, income and life insurance that will cover your debts.

How to use debt to build wealth with Lamna

If you or your business needs funds to exploit an opportunity, we can help.

Lamna offers fast, easily accessible loans against personal assets of value, from vehicles or luxury watches to artworks. This means it’s possible to unlock the value of these assets, quickly and without having to sell them.

For more information about using an asset to secure a short-term loan, contact us on 086 111 2866 or simply complete and submit our online application form.