Debt is the dirty four letter word that everyone is afraid of. There are so many television shows, books, and magazines devoted to teaching people about getting out of debt. While debt can be a negative, it can also be a positive thing if used properly. Here are five ways that debt can make you richer.
In Pictures: Digging Out Of Debt In 8 Steps
Debt can be used as leverage to exponentially multiply your returns. What is leverage exactly? Leverage is using borrowed money to increase your return on investment. Leverage can allow you to achieve returns that you thought were impossible, but at a greater risk of losing your capital.
- Margin Investing
Investing on margin allows you to buy a higher dollar amount of stock than you actually have money for. For example, if you had $50,000 in your traditional brokerage account, you could leverage your investment and open a margin account. A margin account allows you to only put up a max of 50% of the purchase price of a stock. You would have $50,000 in cash and an additional $50,000 would be loaned to you from your broker. Your $50,000 investment gives you $100,000 worth of buying power. You could use this money and buy $100,000 worth of stock.
If the stock price appreciates then you can pay back the loan and pocket the profit. That sounds great! The negative is that if the equity in your account falls below a certain value, your brokerage firm can issue a margin call. What is a margin call? Think Michael Douglas in the movie "A Perfect Murder". Your broker can liquidate your entire position in a stock leaving you broke.
- Leveraged ETFs
Leveraged ETFs allow investors and traders to amplify their returns by getting long or short on a particular index. Fund companies like Proshares offer leveraged ETFs that let investors multiply returns (and losses) 200% and 300%. These funds let you invest in specific indexes, bonds, commodities, or sectors. Leveraged ETFs are attractive because of the extraordinary profit potential. During market booms, you can achieve returns with leveraged ETFs that other investors dream about.
The problem is that the same way that leveraged ETFs work for you is how they can work against you. Unless you are great at trading in and out of these funds, leveraged ETFs can magnify losses by wiping out your entire investment in a few days. (Learn more in Dissecting Leveraged ETF Returns.)
- Hedge Funds
As we all learned during the financial crisis, hedge funds are some of the biggest users of leverage. Hedge funds are famous for generating abnormal returns by using leverage. Many hedge funds lever up to 10 times their total assets. Billionaire hedge fund managers like John Paulson have used leverage to turn accredited investors into multimillionaires.
However, if the fund manager's investment thesis is wrong, this can drive a hedge fund out of business and lose the capital of all investors. Hedge funds such as Long Term Capital Management, which needed a bailout, were levered up as much as 30 times their assets. (Learn more in our Taking A Look Behind Hedge Funds.)
- Short Selling
Have you ever watched a financial program on television and heard that it's time for you to short the market? Short selling is a popular way of betting against a particular security by borrowing shares from an investor and selling them in hopes that the shares decline.
Short sellers like Bill Fleckenstein have made a fortune by properly timing declines in stock prices. The downside to short selling is that losses are unlimited which means that short sellers can lose much more than the initial investment.
- Currency Trading
Currency trading allows investors to control large blocks of currency with a small amount of money. Currency investors can lever up their accounts 100:1. The pros of currency trading are that you can take a small amount of money and turn it into significant sums very quickly. George Soros is known as the "man who broke the Bank of England" netting $1 billion by betting against the pound. Conversely, currency trading has the potential to clean out a trader's account in a matter of minutes. (Try out our currency trading simulator today and see what it's like to be a forex trader: FXTrader.)
The Bottom Line
It may go against conventional wisdom but if properly used, debt can make you rich beyond your wildest dreams. If you have any doubts about it, just ask George Soros.
Catch up on the latest financial news; read Water Cooler Finance: More Spilled Oil, Fewer Jobs.