A recent video of ours where I suggested that blindly following ancient advice was not conducive to wealth creation has received some negative comments. The ancient advice was something my father quoted to me and that many people quote regularly, “neither a borrower nor a lender be”, a quote from William Shakespeare's Hamlet, and offered by a father to a son when the latter is about to go on foreign travels. Indeed, as I mentioned in my video, this was probably top-class advice back in 1592 and remains good advice in many circumstances today, but my point is that when it comes to generating wealth, it is not always the best advice.
I agree that borrowing for shoes, holidays, or cars, or indeed, any consumer consumables is not the best idea and all that does is mushroom the costs of these items. However, there are circumstances where borrowing can increase the potential outcomes of certain investments too and failing to borrow due to some 400+ year old mantra, no matter how well-meaning those that repeat it may be, can mean investors missing a trick.
Borrowing Pros and Cons
- Good Idea: Investments with higher return rates.
- Bad Idea: Consumer consumables (shoes, holidays, cars).
The point I made in my video was this: if you can borrow money at one interest rate and invest that money at a higher rate, then you are using other people's money to make yourself profit. My other point is that some interest rates in Ireland are tax-deductible, which means the actual rate is lower than the headline one, making outperformance that much easier to achieve.
Strategy for Wealth Generation
- Borrowing at lower interest rate: Investing at a higher rate for profit.
- Tax-deductible interest rates: Makes outperformance easier in Ireland.
Let's imagine you have a lump sum of €300,000 available and you are considering buying a rental property and paying cash. Using your own money will mean full taxation and levies (PRSI and USC) on rent and, when you eventually sell there will be capital gains tax too. So, what kind of net return might you expect?
Cash Purchase vs. Loan Backed Investment
- Cash Purchase: Lower due to full taxation and levies.
- Loan Backed: Higher, leveraging tax-deductible interests.
Now, let's break down the numbers in detail to compare the returns on investment using cash versus a mix of cash and loan.
Detailed ROI Comparison
- Cash Purchase: Annual Rate of Return -5.35%.
- Loan Backed Investment: Annual Rate of Return -5.90%.
- Investment with Equity Bond: Annual Rate of Return -6.65%.
Conclusion: Changing how the investment is funded, by using other people’s money, can deliver more wealth, showcasing the benefits of leveraging debt intelligently. By understanding the intricacies of taxes, interest rates, and investment returns, it's possible to significantly enhance the efficiency and outcome of your investments.