How to Use Debt to Build Wealth
7 Min Read | Published: June 19, 2024
This article contains general information and is not intended to provide information that is specific to American Express products and services. Similar products and services offered by different companies will have different features and you should always read about product details before acquiring any financial product.
There are several ways that you can use debt to grow your wealth. It’s important to take on debt for the right reasons and with a clear strategy in place.
At-A-Glance
- Certain types of debt can be classified as “good debt” that can be used to build wealth.
- Mortgages, business loans, and student loans can be forms of good debt.
- Assessing your risk tolerance for debt can help you create a wealth-building strategy that works for you.
Debt is often associated with financial burden, but careful and strategic debt use can be a powerful wealth-building tool. There are several different ways to use debt to grow your wealth, but you’ll want to be aware of the risks associated with each one.
In this article, we’ll look at some potential ways to use good debt as a tool to grow your capital and steps to create a wealth-building strategy that works for you.
Understanding Good Debt vs. Bad Debt
Debt used to purchase assets that can grow in value is considered good debt.1 Mortgages, student loans, and in some cases, business loans are examples of good debt because they can produce an investment return or gain.
On the other hand, bad debt is debt that may deplete your finances and, in some cases, even damage your credit. High-interest debt is typically considered bad debt, especially if the debt is used for something that offers no chance of an investment gain. Bad debt creates a financial strain, it isn’t a wealth-building opportunity.
Debt That Can Be Used to Grow Your Wealth
Learning how to use debt to build wealth can change how you view finance. There are several ways to leverage debt effectively, including low-interest financing for investment opportunities and utilizing leverage in real estate transactions. As with any investment, though, these investments are not without risks. Be sure to carefully consider the potential risks before investing in them.
With this in mind, let’s take a look at three examples of how debt can be used to grow your wealth:
- Mortgages
Taking out a mortgage to buy a property can be classified as good debt. A mortgage can allow you to gain access to housing, and if you purchase in the right location, where property values are increasing, then your home may even appreciate in value over time, allowing you to potentially sell it for more than you paid. A mortgage on an investment property is also considered good debt, as you could be able to use the rental income (in addition to potential appreciation) to invest.
Note that the exact return on investment (ROI) you’ll get for a rental will vary, depending on factors including location, the type of property you buy, and the financing you’re able to secure. It may be advisable to target a return of between 8% to 12% if you buy a residential rental property.2 As a comparison, the average annual stock market return for the past twenty years was 6.96% (with dividends) when adjusted for inflation.3 - Business Loans
Taking out a loan to infuse cash into your business may or may not classify as good debt. It’s how you use the money that matters. Investing in the marketing of a new product line could result in increased sales and higher profits. Using that same cash to throw a party for your employees might help boost company morale, but it won’t necessarily bring in new revenue.
The risk with business loans is that your company needs to pay them back. That’s easier to do if you invest the money into marketing or growth projects. Evaluate that carefully before you take out a business loan. While you’re at it, you’ll want to consider a business line of credit. They’re a more flexible way to finance a project or product launch if you don’t need all the money upfront. - Student Loans
Borrowing money for student loans can be another form of good debt. Student loans allow you to invest in your future, helping you to gain the skills that you need in order to obtain a certain job.
Before taking out student loans, it’s a good idea to carefully consider how much your future job is likely to pay once you graduate, and calculate how many years it will take you to pay the loans back.
Creating a Strategy to Build Wealth With Debt
Depending on your risk tolerance and investment goals, there are a number of different ways you could potentially use debt to build wealth. Here are a few steps that can help you to get started:
- Assess Your Comfort Level
This is also known as doing a risk assessment. Paying cash to buy a few stocks is less risky than buying a building and becoming a landlord. How much risk are you willing to assume? The answer will help define your investment strategy. - Know Your Credit Score
Your credit score is a key factor in obtaining certain types of credit from a lender. You can check your credit score online at Experian®, Equifax®, or TransUnion®, the three major credit reporting bureaus. You can also obtain your free credit score and credit report using a service, like MyCredit Guide from American Express.
- Consider Your Long-Term Goals
Make a list of your long-term goals and estimate how much you’ll need to achieve them. Be sure to include your retirement savings and income needs. Your goals will help you choose the right investments for you. - Assess Your Cash Flow
Healthy cash flow is essential if you use debt to build wealth. Lenders will want to see what you have for resources before approving you for funding. Cash flow is also your backup if investments don’t pan out. - Develop Your Investment Strategy
Your risk evaluation, credit score, long-term goals, and cash-flow situation are the building blocks for an investment strategy. Use them to select the debt investments that are a good fit for you. - Diversify Your Portfolio
To minimize risk, investors can diversify their portfolios. For example, buying stocks on margin can be offset by low-risk investments like bonds or mutual funds. Speak to your financial advisor to learn more.
What About Investing In Debt?
It’s important to note that there’s a big difference between investing with debt and investing in debt. Investing with debt involves using debt to increase your wealth. Investing in debt, on the other hand, refers to debt investments.
Examples of debt investments include fixed-income products like bank loans and bonds.4 Cash-strapped companies often prefer using these debt instruments instead of issuing and selling new shares of stock that will dilute the value of the existing shares. Investing in debt could help you diversify and stabilize your portfolio, and these instruments are considered suitable for low-risk investors.
Frequently Asked Questions
Commercial and residential real estate can produce high returns for investors, but it also has its risks. The viability of real estate investments varies considerably depending on a number of factors including location, property type, and the type of financing that you are able to secure. Steps you’ll want to take include conducting a careful market analysis, considering projected income versus expenses, and assessing potential returns as compared to risks before buying a commercial office building or residential rental property.
Taking on debt to invest or buy assets that can grow in value can be a good way to build wealth, but this strategy isn’t without its risks. It’s important to remember that all investments carry a level of risk, so be sure to carefully consider the potential risk alongside the potential returns when assessing a potential investment.
The Takeaway
There are two different types of debt. Taking out a loan to make an investment or buy an asset that will grow in value is called “good debt.” Careful and strategic use of good debt can be used to build wealth. Bad debt, on the other hand, can damage your finances.
1 “7 powerful ways to use debt to build wealth,” Delta Financial
2 “What’s a Good ROI For Rental Property?,” Bay Property Management Group
3 “Historical Average Stock Market Returns for S&P 500,” Trade that Swing
4 “Debt Financing,” Corporate Finance Institute
Kevin D. Flynn is a financial services provider, business coach, and financial writer. He lives in Leominster, Massachusetts, with his wife Evelyn, two cats, and ten wonderful grandchildren.
All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.
Related Articles
7 Savings Challenges to Boost Your Bank Balance
Make saving fun! Learn several fun money-saving challenges to help you save money. Develop healthy financial habits that can help you reach your goals.
What, Exactly, is “Personal Finance”?
Understand what personal finance is, why it is important and how you too can do personal finance to help you manage your money.
What is Financial Planning and How Does it Work?
Personal financial planning can help protect you from life’s unpredictability. Find tips to improve your financial planning process and learn to build a budget.
The material made available for you on this website, Credit Intel, is for informational purposes only and intended for U.S. residents and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.
Shop All American Express Credit Cards
