Three very simple investing golden rules for spending borrowed money

Former lawyer and City money man Peter Alcaraz discusses debt and compounding as wealth promoters, and the ingredients needed to double your money.

Peter Alcaraz read law and economics at Durham University and spent 24 years advising small and mid-sized companies on mergers, acquisitions, IPO's and fund raisings, first as a lawyer and for the last 20 years in corporate finance. At the age of 46 after reaching 'O' he left city life to write, study, travel and spend more time with his wife and two daughters. His first book, The Wealth Game - an ordinary person's companion was published in 2016 and has become a staple among wealth managers, business schools and private individuals wishing to develop their personal finance skills.

• How you can achieve financial freedom more quickly
• How to calculate your real net worth
• How to calculate your total future needs and retire early
• How to keep a firm grip on cash flow and preserve your wealth
• How you can generate more surplus cash flow
• Rules and strategy for achieving financial freedom quickly
• How being contrarian can help you win the wealth game
• Some basic laws of finance to help you spot a wealth opportunity 
• The seven big drivers of share prices and when to buy

As a lender or 'creditor', there's something solid and reliable about debt. You can tether to it for a while, safe in the knowledge that you've fulfilled your side of the bargain and that it’ll deliver a set return over a certain time frame as long as the borrower doesn’t default. It’s a perfect asset if you want low or no risk and certainty of financial outcome for minimal effort.

For a borrower or 'debtor', the tables are turned, and instead of paying now to receive later, you receive now and pay later. Your obligations begin with the loan and disappear only when you have repaid it along with all the interest accrued during its term, which may run for years.

In terms of effort and obligation it's a one-sided contract loaded in favour of the lender who can relax in the sun and live off the interest while the borrower toils to repay it. Of course, if the borrower lends the money to someone else at the same or a higher rate of interest, then the obligation to toil passes to that person.

Let's say you borrow £1,000 at a cost of 5% per annum interest for two years. You could spend the money on a holiday and work to pay off the loan. Alternatively, you could lend it to someone at 8% per annum for two years, pocket £30 profit each year, and repay your original loan without needing to work for it. Either you work to repay the loan, or you make the loan work for you. One approach is a recipe for hard work and pressure; the other, a basis for wealth creation.

Here, I focus on the borrower's tale. Of the eight certain features of debt I discuss in my book, here are two headlines:

(i)    If the cost of debt is less than the return generated on the money borrowed, value is added. If it is greater, value is destroyed.

The cost of debt for this purpose is the interest charged plus arrangement fees. The return is income and capital gain on the investment generated over the period of the loan. In the simple example of financial engineering above, you borrow at a cost of 5%, earn 8% on the money and make 3% per annum profit. If the numbers are reversed, you make a loss of 3% per annum.

(ii)    Debt magnifies returns or losses when added to a project.

Whereas compounding works slowly to grow or destroy value, debt turbocharges results, whether good or bad. The proper use of debt enables the ordinary person to act as a private-equity investor and create the equivalent of leveraged buyout structures around particular assets, creating maximum effect from minimum effort—or in this case, minimum equity.

How does it work? Since debt remains constant, all gains and losses of an investment go to the value of the equity. Debt acts as a multiplier.

For example, assume that Sarah and Tim have £100,000 each to spend on buying a house. Sarah gears up by borrowing an additional £400,000, giving her a total spending power of £500,000. Tim doesn't borrow and has £100,000 to spend.

Sarah's debt-to-equity ratio is 4:1. Her gearing, also known as loan to value, is 80% (debt / total assets × 100 = £400,000 / 500,000 × 100 = 80%).

If both Tim and Sarah's properties increase in value at 5% each year for five years, in year five Sarah's house is worth £638,000. Her mortgage is unchanged at £400,000 giving her equity of £238,000 and a gain of £138,000. Tim's house is worth £128,000 which is also his equity value as he has no borrowings and his gain is £28,000. Sarah's gain is 4.9x Tim's!

Of course, Sarah will have had to pay interest on her mortgage. If her loan rate was 3% pa so £12,000 pa, the five-year cost is £60,000 reducing her gain to £78,000 which is still 2.8x Tim's and represents a 12.2% compound annual return on her equity of £100,000 (see CAGR formula in prior article) and a 1.78 x money multiple (£178,000/100,000). Tim's CAGR is 5% pa over the five years. That's a huge difference.

Now play with the numbers assuming that property values fall at 5% pa over the five years!

What's It For?

In November 2013, UK personal debt including mortgages passed its pre financial crash peak at September 2008 - just five years later! The number was so large as to be almost incomprehensible: £1.43 trillion, which is £1,430,000,000,000, or £1,430 billion. In June 2018 it was nearly £1.6 trillion.

That's a lot of debt-so much so that the Bank of England has warned that the "household-debt hangover" must be prioritized as the "holiday period" of low borrowing costs comes to an end and that a “modest increase in interest rates could render almost 25% of UK households in severe financial stress.” Of these, 1.1 million UK households could be in “debt peril” meaning that they spend more than 50% of their income on debt repayments.

It would seem a good time to ask why we borrow. There are only two reasons:
1.    To buy something now that we couldn't otherwise afford

Instead of waiting until you have saved enough money to pay for something, you buy it now and pay later. It's the commonest purpose.

2.    To increase our wealth through financial engineering

So far, I have emphasised the importance of creating surplus cash and putting it to good work in appreciators. Wasting your own money destroys wealth. Borrowing someone else's money and wasting that is the equivalent of committing financial suicide.

Here are two very simple golden rules. Spend borrowed money only on assets that (1) will not fall in value below the amount of the loan and (2) will produce a return higher than the cost of the borrowing.

Your asset can fall in value but not below the loan principal, so unless you have a rare asset whose value will never fall below a certain amount, create a safety margin by borrowing less than its purchase price.

If you follow these rules, as long as you can service the cost of the loan and aren't forced to sell the asset at a low value point, you'll be okay. Spending borrowed money on depreciators and consumables is folly. You should borrow only to fund appreciators (preferably productive ones).

But do you really know what you are borrowing for? I call this problem 'disguised borrowing' and it is routinely overlooked in the game. As soon as you borrow money, you have a debt liability in your personal balance sheet. From then until the loan is repaid, money spent on anything other than repaying that loan is effectively borrowed money. Don’t associate borrowings with a particular asset or purpose like a kitchen or a car or a holiday, it’s just debt...

You might think that because you are comfortably paying the interest on your mortgage or car loan and can see a way to repaying it in the future, surplus cash is yours to spend. It is not yours; it is borrowed. Only when all your borrowings are repaid is it yours. Every pound you choose to spend rather than to repay debt is a borrowed pound. You are borrowing to spend.

Now reread the two golden rules. Are you behaving prudently?

A further golden rule emerges: in order to reach O in the quickest time, apply all surplus cash to repay borrowings or to investments whose returns exceed the cost of those borrowings.

Whether it is better to repay debt or invest in higher-returning assets depends on the circumstances of the day. When standard mortgage rates jumped from 7% to 13% per annum in a few short stages during the early 1990s, it was an easy call to repay debt quickly. When interest rates and mortgage costs dropped to 0.5% per annum after the 2008 financial crisis it was worth holding the loan and investing in recovering assets.

Remember that personal loan interest is paid from taxed income, so the effect of repaying debt charging 5% per annum is equivalent to a pre-tax saving or return of 6.25% per annum for a 20% taxpayer and 8.3% for a 40% taxpayer.

Where else can you earn a guaranteed, risk-free, tax-free return that consistently beats bank deposit rates? A mortgage or other loan secured against an appreciator is a superb investment and savings vehicle. First, borrow money to purchase a higher returning asset, then divert spare cash to repay part or all of the debt that cuts your financial risk and earns you lenders' rates, tax-free and compounding monthly. Repayment releases capacity for future borrowings, opening the door to buy and hold or build strategies discussed later. It’s a complete no-brainer.

The case for early repayment is beyond doubt for loans taken to purchase depreciators like home improvements or cars or for credit card debt. Your return can't possibly exceed borrowing cost so it's all downhill. Repaying an unsecured personal loan or a credit card debt costing 28% per annum delivers a return that even private-equity investors would get out of bed for.

Playing the private-equity game

In my early days of work, I was always painfully aware of being simply a paid hand with no stake in the business. Looking around, it was the same for a junior analyst or a managing director, barring a few share options granted along the way. "It's an income game," the head of the business told me at appraisal time. The income was indeed good relative to national averages, and it made plenty of my colleagues feel rich, or at least spend as if they were, but to me, it was just income—and heavily taxed at that.

How could I compete with partners in their own firms or owners of businesses who could earn the dividends of ownership as well as a capital gain when their business or share of it was sold? The glamour and kudos of working in a well-paid job seemed superficial and pointless in comparison, as I had no interest in showing off or feeling superior because of my chosen career. In fact, the years of study and training to gain professional qualification seemed more like a trap, holding me down and demanding that I put in the time and sweat to reap adequate financial rewards for all these efforts. To take a risk and become an entrepreneur now seemed foolhardy and unjustifiable. If I had left school early, learned some practical skills, and had a few more years in hand with less fear of losing if it all went wrong, now that would have been different.

The challenge was simple: how to reach O when I didn't own equity in the business, and the profits of my hard work were going to others. I had no interest in thinking and behaving rich when I was clearly not, resigning myself to a working underclass and giving up completely, or getting bitter and twisted with frustration.

The solution slowly dawned and now seems as clear as day:

a.    Get paid as much as possibleb.    Use salary to borrow money to buy residential propertyc.    Add company shares to the potd.    Feed cash from earnings to service and repay debte.    Watch the virtuous circle begin as assets begin producing and debt capacity grows.

Suddenly, I had an equity base. All my efforts in buying, funding, and managing assets were for my own benefit, not someone else's. This equity base was simply a separate 'business' from my day-to-day workplace.

In this way, use your day job to fund a private-equity strategy. Private-equity or venture-capital investors make money by buying businesses, incentivising management through an ownership share and gearing up with debt. Cash from the business services debt and repays part or all of it while equity value grows, benefitting the owners. If the business can be made to perform better or if its prospects for future profitability can be improved so that it can attract a higher price multiple on sale than on purchase, even more value will be added for equity holders. When it works, the model is entirely self-sustaining without the need for more equity to be added.

Instead of buying private businesses, buy productive appreciators; residential property, and quoted company shares. You have the added benefit of a steady source of equity from outside your growth pot (your earned surplus cash), as well as that generated by the assets themselves.

Compounding

Compounding is as natural as time itself, a spiralling escalator that never stops. Whether you stand on it and effortlessly glide upwards or take extra steps to boost the process, it offers a unique advantage to travellers over those who choose to plod up the staircase alongside. It's a free service without age threshold or limit, available to you 24 hours a day, 365 days a year, every year. There's always room for you and no need to book. You just turn up and get on board.

Why spiralling? Because it tracks a virtuous circle of wealth building, adding force to the natural upward motion of this wheel of fortune. How does it add the force? By applying returns to assets and to their previously accumulated returns.

Picture an asset wheel where all the returns on assets, both income and capital, are removed and spent on depreciators and consumables or given away. The only propellant to this wheel is new cash from outside. It still spirals upwards but very slowly. If the cash tap is turned off the wheel will stop and begin to reverse as the drag of inflation overpowers it, a downward spiral towards zero value.

With compounding present, some or all of the income and capital gains generated by assets is kept inside the wheel and as it rotates, further income and capital gains accrue to the enlarged vehicle and so on, generating exponential growth. The wheel becomes a self-sustaining wealth-creation machine. It's the greatest gift in the wealth game.

Here are three simple guides:

(i)    The more time your assets can compound the better, so start now

The slow, deliberate nature of compounding doesn’t inspire news headlines or grab one's attention. By its nature, its effects are glacial. Many people aren't even aware of it as a personal finance concept. The first they might hear of it is towards the end of a working life, around retirement time, when a financial adviser produces an illustration of future pension payouts and the monthly contributions needed in the meantime to fill a gap in expectations. Perhaps 20 to 30 years of previous compounding opportunity may have been squandered through ignorance, and getting the point now is not much help as time has run out.

The "campaign for compounding awareness" has a big job to do - to somehow help people link outcomes 20 to 40 years into the future with actions now and to properly appreciate this example of cause and effect and its high standing in the financial well-being stakes.

How long does it take for compounding to make a difference?

The analysis in my book shows that compounding effects start slow and small and speed up gaining size like a snowball. The effects of compounding start to become really pronounced after 10 years and ramp up from there, with the average annual return increasing by about 1% pa for every five years that pass. At the five-year mark, the results are uninspiring but compounding simple interest of 5% per annum, the historic arithmetic average return reaches 6.3% per annum at ten years, which is 26% higher than the simple interest rate. At 15 years, it is 7.2% per annum, and by thirty years, it exceeds 11% per annum, a mind-boggling increase.

Every basis point increase in your annual return rate is a gift and this scale of improvement for no added risk massively benefits your quest for O.

The 10-year theme is convenient because it sits well with life periods—for example from 20 to 30 we're getting started in a career and home, single or married but without major overheads; from 30 to 40 we spend on a mortgage and children if they come; and from forty to 50 we are in peak earnings and spending but costs tail off as we head to O. This is a loose framework, and start and end dates will vary. I tended to project in five or seven-year slots to reflect rapid life changes.

(ii)    Feed the machine

Add cash to your compounding pot because these additions generate returns that are themselves compounded. It is like changing to a higher gear on a bicycle on a gentle downhill slope. Gravity alone allows you to cruise but by changing up a gear and pedalling, you go faster and travel farther. If the track levels or turns uphill, the extra momentum you have generated will carry you on, possibly until you reach another downhill section.

A year of weak or negative investment returns will slow wealth gains or reduce net worth for the player who is relying solely on compounding but one who feeds the machine with cash as well has a better chance of staying ahead. This is extraordinarily important because when investments start to grow again both players will start from a completely different place.
Person A's assets may be 10% up and B’s 10% down, a difference of 20% and it is from these value levels that assets begin compounding again. A is at a massive advantage.

(iii)    Maximise your returns

The annual return needed to double your money in 10 years is 7.2% which today is ambitious, although remember how debt can enhance returns. A more conservative return of 5% pa will double your money over 15 years.

Anyone who has ever played backgammon understands the power of doubling dice on the outcome. The more doubles played in a game, the higher the result is ratcheted for the winner. In the wealth game you’re the only player and can’t lose on doubling so the more often you can double, the better.

The ingredients for doubling are: time, cash added to your compounding pot and the investment returns you generate. Attend to each of these equally.

For more pot building techniques, read on to find out….

Peter Alcaraz is a freelance contributor and not a direct employee of interactive investor.