I am often dumbfounded by people who hold huge amounts of personal debt and yet will approach me about making investments with “spare” cash. Some academics many moons ago came up with a theory about how debt creates value and the idea has spread like the plague in my opinion.
If you hold large personal debts, my advice is to pay that debt down before putting cash into risky assets. Paying down debt gives you a guaranteed return of whatever interest rate is being charged on your debt. There is not much guaranteed in life, and most guarantees on investment products are not worth the paper they are printed on.
That said, there is a time and a place for debt, as well as a way to ensure it does not destroy your personal wealth. A mortgage on a property is one time in life when most people are forced into debt, since they would usually otherwise be priced out of the market. Student loans are another use of debt that I generally would encourage, but not for excessive partying and holidays.
When it comes to business investments though, I think it is wise to separate your business finances from your personal wealth. Since more than 90 percent of new businesses fail, if you need debt to set up a new venture the odds should lead any reasonable person to avoid putting their personal credit into the equation if at all possible. If not, you may want to reconsider the venture.
The proper way to utilise debt is set up a limited liability corporation, prepare a detailed, convincing yet realistic business plan, and request a bank loan you money that is secured by the assets which the business will purchase. If you can’t convince a loan officer to lend, there is a good chance you are so close to your idea that you can’t objectively evaluate the merits.
An alternative to debt financing is to sell equity to individuals or venture capital firms, but this a whole separate issue with its own set of potential pitfalls, pros, and cons. If you have a solid business idea and have a professional business plan put together, a bank loan should allow you to keep ownership of your venture. The downside is that debt can be very crippling if it spirals out of control.
It is probably beyond the scope of this article to go into fine detail of the capital budgeting process, but the main point I hope I can drive home is that you should not make all in bets with your personal finances. This common mistake has led to many avoidable personal bankruptcies. Separate the fate of your business with that of your estate. You may have read recently about the famous author of the “Rich Dad, Poor Dad” series of books going bankrupt. While the reason was actually a lawsuit, the case still drives home my point. While many pundits have been quick to write witty columns with jokes about the “rich dad, poor dad, bankrupt dad”, the truth is that the author has kept his personal wealth intact. His corporation declared bankruptcy, but his personal assets were out of reach since it was the corporation which lost the lawsuit.
Keep your personal life debt free as much as possible. The responsible way to utilise debt is within a corporate structure and usually tied to a specific asset. Running a business is stressful enough without having to worry about a personal bankruptcy.
David Mayes MBA provides wealth management services to expatriates throughout Southeast Asia, focussing on UK pension transfers. He can be reached at firstname.lastname@example.org. Faramond UK is regulated by the FCA and advises on pensions and taxation. Views expressed here are his own.