Debt as a Negative Investment

Debt does two things;

  • It increases risk
  • It reverses the law of compounding

I would like to start by noting that every financial guru I know of discourages personal debt; even those who boldly proclaim that “cash is trash” as well as those who promote business debt, leverage. The companies that, to my knowledge, most actively promote personal debt are banks, credit card companies and loan sharks Makes you wonder, doesn’t it?

In today’s article we will consider how debt reverses the law of compounding.

Question: Do you have both investments and personal debt?

  • What return are you getting on your investments?
  • What interest are you paying on your debts?

How much of your investment returns are being cancelled out by the interest you are paying on your debts?

Here is a simple example;

  • Credit Card debt at 20%: R100,000 multiplied by 20% = R20,000 interest/year
  • Return on Investment at 8%: R20,000 divided by 8% = R250,000 investment.

This means that, on a year by year basis, the R20,000 p.a. interest being paid on the R100,000 credit card debt effectively cancels out the return on a R250,000 investment at 8%. How cool is that?

If the return on the R250,000 is reinvested and the R100,000 credit card debt is being serviced from personal income, in ten years the financial picture would look something like this;

If the 8% return is reinvested, after ten years the R250,000 will grow by R304,000 to R554,000 while R200,000 interest will be paid on the credit card debt. That is a nett gain of only R104,000.

This is what the balance sheet looks like in Years 1 and 10.

Before you think it’s not too bad, consider that the R200,000 paid in interest is sitting on someone else’s balance sheet, not on ours. It’s effectively lost.

Is this the best use of capital?

Is having a positive investment of R250,000 at 8% and a negative investment of R100,000 at -20% the best personal use of capital if we want to become wealthy?

What would happen if one used R100,000 from the positive investments to pay off the negative investment (i.e. credit cards) and then closed the credit card accounts?

One would be left with

  • A reduced positive investment of R150,000 at 8%
  • An additional R20,000 per annum to invest at 8%
  • Zero negative investment.

What would this be worth over ten years?

After ten years the combined investment is worth R637,856 with zero credit card debt.

The balance sheet now looks like this in Years 1 and 10.

As you can see, the R200,000 that was going to interest on the credit card debit is not only showing up in the balance sheet in Year 10, it has increased by over R104,000 for a nett gain of almost R200,000 better than the previous example.

Can one do better?

What would happen if one could upgrade one's skills and achieve a higher rate of return, like 15%? In Wealth Diamond this would be upgrading from an Ignorant Passive Saver (“I know nothing about investments”) to an Intelligent Passive Investor (Benjamin Graham’s Defensive Investor who “seeks safety with least concern”).

By achieving a higher rate of return with the same amount of money, the investment is now worth over R1,100,000 with zero credit card debt.

And the balance sheets in Years 1 and 10 look like this.

Can one do even better?

What if one could upgrade one’s skills from an Intelligent Passive Investor to an Intelligent Active Investor (Benjamin Graham’s Enterprising Investor who “applies maximum intelligence and skill”) to achieve an even higher rate of return?

I will leave this scenario for a later discussion with clients. But watch this two-minute video on Warren Buffett, Benjamin Graham’s most successful disciple, and his partner, Charlie Munger, discussing returns on a $1,000,000 investment.

The key phrase in this video is “if you are willing to work at it”; that is the key to becoming an Intelligent Active Investor. Anyone who want to accelerate their returns with least risk, must be willing to work at becoming “an alert and enterprising investor who exercises maximum intelligence and skill”.

The minimum return goes to the passive investor who wants both safety and freedom from concern. The maximum return would be realised by the alert and enterprising investor who exercises maximum intelligence and skill. (Benjamin Graham, The Intelligent Investor)

As you can see from the examples above, investing really is simple maths. Just add increasing amounts of “intelligence and skill” to achieve better results.

I wish I had believed that when I was in my twenties and thirties and forties and fifties! But there’s still hope;

The best time to plant a tree is twenty years ago. The next best time is now! (Japanese proverb)

Now is the only time we have to make tomorrow better.

Disclaimer: This article is not financial advice but rather a challenge to the reader to consider increasing their investment skills so that they are better equipped to take personal responsibility for their financial well-being.

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