Borrowing Options: Benefits and Dangers of Borrowing

Succesfully borrowing and paying off your loans as agreed can help you establish a good 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 possible because you can own and control more property with less of your own money. The following illustrates how you can increase the return on your investment using leverage:

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.

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.

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.

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, it is easy to 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 a fee (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.

In addition to the excessive interest, 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 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 significant assets, 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.