Turning Debt Into Wealth

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Turning Debt Into Wealth: Why The Wealthy Investors Are Borrowing Like Mad

by Alexander Green, Chairman, Investment U
Monday, April 16, 2007: Issue #662

Lately we’ve all heard plenty about rising defaults in the mortgage market. But most of the damage, so far at least, is in the subprime sector. These are borrowers with poor credit records to begin with.

However, we’ve also heard plenty of rumblings in the media about the “indebted middle class.” These are people struggling with credit card debt, personal loans and more traditional home equity loans.

But it turns out the guy who is really piling on the debt is not the blue-collar guy down the street, or even the white-collar guy next door. It’s the guy in the tweed jacket on the hill

A close look at the nation’s borrowings shows that the rich are piling on debt faster than anybody else. And you may be surprised to find out they are actually turning debt into wealth. Before I explain how, let’s take a look at some statistics that back this all up

America’s Richest Are Turning Towards Debt

According to the Federal Reserve Board’s Surveys of Consumer Finance, the nation’s richest 1% loaded up on $342 billion in new debt between 1998 and 2004, the latest year for which data are available. (For the record, the richest 1% are households with net worths, including primary residence, of at least $6 million.) Economists say that debt number has probably increased over the last two years, since interest rates have remained at historically low levels.

The rich have always controlled a disproportionate share of national wealth. But it’s a bit surprising to learn that they also account for a disproportionate amount of debt. The richest 1% now hold 7% of the nation’s total consumer debt, with a total of $650 billion in borrowings, up from 5% in 1998.

And debt is growing faster for this group than any other group in the Fed survey. Total debt held by the top 1% increased 150% between 1998 and 2004.

Just what are these rich folks up to, anyway?

How To Turn Debt Into An Extra $40,000

Unlike the middle class guy who is often borrowing so he can get his hands on that new car or a big-screen plasma TV, the rich are using debt for a different reason: to make more money.

According to The Wall Street Journal, “Today’s rich are more comfortable with risk. In a world awash in cash, many of today’s wealthy made their fortunes by leveraging and making big bets with their businesses. They’re applying the same principles now to their personal wealth.”

This can be a smart move. Clearly, if you can borrow money at 6% and earn a return of 10%, your million dollars can pull in an extra $40,000 a year.

Middle class investors can do the same thing, but on a smaller scale. One of the easiest ways is by purchasing stock on margin.

Your broker will generally let you borrow an amount equal to the equity in your account. That means if you own $50,000 in marginable securities (in a non-retirement account), you can borrow against that equity to purchase another $50,000 worth of stock.

Setting interest costs aside for a moment, a 15% return on your newly leveraged portfolio becomes a 30% return on your $50,000 worth of equity.

Use Caution When Trying To Turn Debt Into Wealth

So far, so good. But leverage is a double-edged sword. If your investment portfolio declines, your borrowing magnifies your losses the same way. A 15% drop in your leveraged portfolio translates into a 30% loss in the net value of your account.

For that reason, most investors should use leverage only when they have a high degree of confidence in the outcome of their investment. And even then, they’re better off using margin sparingly.

So, yes, the rich have lately been borrowing like there’s no tomorrow. But most of them are not trying to keep up with the Winchesters.

Rather, they’re using debt the smart way: as a financial tool to generate higher returns and still greater wealth.

Good Investing,

Alex

Today’s Investment U Crib Sheet

So what, exactly, are the “rich” borrowing money to invest in? Our recent report shows you what the world’s top money managers are recommending to their wealthiest clients right now – a list of opportunities open to individual investors as well. Read the full report.

Wealthy investors are also getting richer from the, Private Equity frenzy Over the past 12 months, private stock investors have poured more than $378 billion into the market for private companies – or “non marketable securities,” as Wall Street calls them. Warren Buffett’s getting in on the action, too

In fact, private equity has quietly become the cornerstone of Buffett’s investing strategy at Berkshire Hathaway in recent years. In his 2006 letter to shareholders, he says:

“In our early years, we put most of our retained earnings and insurance float into investments in marketable securities. Over the years, however, we have focused more and more on the acquisition of operating businesses [private companies].

“Large gains from here on in will come only if we are able to make major, and sensible, acquisitions [in private equity]“

According to Barron’s, the private equity market is worth an estimated $1.3 trillion.