Do the Rich Use Debt Differently?

When I was a mainframe computer programmer and project manager, we used a relational database product from IBM called DB2. Programmers would code a call to DB2 and the software it had would figure out the best way to go get the data and present it back to the program. It was nearly impossible to figure out exactly how the program would work for each query, because, as Bonnie Baker (the engaging and energetic DB2 speaker) used to put it “It depends”.

Likewise with understanding whether the rich use debt differently than the rest of us…. it depends.

It depends on risk tolerance.

Just because you manage to accumulate lots of money doesn’t mean that you suddenly get comfortable being in debt. Take my spouse and I. We have different levels of risk tolerance. His is near the zero end of the scale and mine is more towards the middle. I was willing to take on mortgages, it drove him crazy with stress.

When you take on debt, you take on a level of risk. Even when the debt is ‘good’ debt (aka leverage), you assume a risk. For all of the upside benefits, there are definite downside problems.

It depends on your definition of “Rich”.

Trying to put a number on what it means to be rich is impossible. Richness is subjective. Many have tried, via surveys, to define what it means to be rich – either in annual income or in net worth.  The answers are all over the place, and sometimes depended on what the current wealth or income level of the respondent was.

Use of leverage (aka debt) by a person earning $200,000 (Obama’s definition of rich), but with a small net worth may be less likely than the use of leverage by a person who has the net worth to cover the amount of debt incurred.

It depends on what kind of debt you consider.

Rich people (no matter what your definition) avoid debt that doesn’t pay. For example, in How to Become a Millionaire by Age 30 the author claims that:

“Rich people use debt to leverage investments and grow cash flows. Poor people use debt to buy things that make rich people richer.”

Poor people use debt to get things they can’t afford to achieve a lifestyle they want but haven’t yet attained.

It depends on how the debt is managed.

Poor people let debt become their master and spend their lives toiling to satisfy its demands. Rich people make debt their servant.

For example, in Huffington Post article, Rich People Don’t Put Their Money in Jars, the author points out this path to managing debt wisely:

“Instead of paying off your home or all of your student loans early, start focusing on reducing the interest to four percent or lower and compounding your investment gains at 10 percent or higher.”

In other words, pay the minimum on your student debt instead of the max you can put together. Then invest the difference between the minimum and the max somewhere to earn a higher rate than you are being charged.

To manage debt wisely:

Ask yourself if you will be able to sleep at night if you take on this debt.

What tolerance do you have for risk? Don’t damage your health by taking on voluntary debt if it will stress you out.

Ask yourself if your debt will pay YOU.

Unless your new boat will provide an income, it is doubtful that it will pay you. You will be feeding it instead. Don’t take on voluntary debt unless it will increase your wealth.

Ask yourself if you are borrowing at the best rate.

If you decide to take on debt, shop around for the best rate, including any fees that come along with it.

Ask yourself if you are borrowing the right amount.

While it may be tempting to borrow ‘just a bit more than I need’, don’t do it. The excess money may just disappear with no benefit to you. One of my nieces did this when borrowing for college. Now she has much more debt than her education should have cost.

Ask yourself if you are borrowing from the best place.

Rich people can borrow from their brokerage accounts, typically at lower rates and with less hassle. A bank might be reluctant to take on a large loan, but if you already have that much money in your broker account, leave it there to continue to earn money, and borrow against it if you deem it wise to have this debt.

Ask yourself if you could pay the debt + interest now if you needed to do so.

Rich people tend to have enough backing to get themselves out of debt at will if need be. Don’t leverage your margin account with a put or call that could cascade way out of control and out of the bounds of your ability to pay the margin call should it come.

Do we treat debt differently now that we are financially free?

Not really. My spouse is still very risk averse and I won’t stress him out by taking on debt.

The only debt we have is temporary – credit card charges that we pay off each month so we don’t get charged any interest. If we did take on debt, it would only be because we could earn more than the debt cost us.

Do you think that wealthy folks use debt differently than the rest of us?

Leave a Reply

Your email address will not be published. Required fields are marked *

I appreciate your readership and really enjoy hearing your thoughts on different topics. Thank you for contributing to the discussion.