How To Use Debt To Build Wealth

Many financial advisors and money-management coaches will encourage you to get out of debt as quickly as possible. There’s a lot of wisdom to this advice, especially if you’re one of the 32% of Americans who have over $1,000 in credit card debt, according to a recent GOBankingRates survey.

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But what you may not hear as often is that not all debt will sink your finances. In fact, when used wisely, certain types of debt can help you earn a profit in the short and long term.

“When trying to build wealth using debt, the idea is to invest the money and generate a positive net cash flow,” said Ron Tallou, founder and owner of Tallou Financial Services. “The money you borrow from a lender needs to be paid back with interest every month, so you’ll want to collect enough [from your investment] to cover the payments and more because you’re not doing it to break even.”

Interested in using debt to build wealth? Here’s what you need to know, according to financial and business experts.

Do Your Research First

Before taking out a loan, you need to understand the asset you’re planning to purchase, said Taylor Kovar, CFP and owner of Kovar Wealth Management and

“Don’t use debt to buy anything you’re not extremely familiar with,” he said. “Most people get into trouble by buying something their friend told them about.”

Instead, be sure to study the market you’re interested in so you know the right time to buy. You also should thoroughly research the loan, along with its interest rates, potential fees and repayment schedule.

Focus on Cash Flow

Some assets can help you build wealth in the long term without yielding immediate cash, such as a primary residence that you don’t rent out. But it’s better to focus on assets that can quickly produce income, said Coco Dee, chief wealth officer at Female Financial Literacy Library.

“We know cash flow is king, both personally and professionally,” she said. “So using debt to increase your net cash flow position is the aim when building long-term wealth. When debt is used in this way, it’s less likely to create financial stress or a situation where the debt becomes insurmountable.”

Have a Backup Plan

Dee also recommends having a Plan B for any loan you plan on taking out. For example, second-tier or private lenders often have shorter loan repayment periods. So make sure you can realistically pay back the initial capital within the agreed timeframe, even if an unexpected setback occurs.

“Factor in worst-case scenarios so that you aren’t in a pickle when things don’t go according to plan,” she said. “Reducing your exposure and stress levels is key.”

Choose Reliable Partners

Are you thinking of going into debt with or borrowing from someone you know? If so, make sure the partnership makes sense from a professional and financial standpoint.

“Be sure your values are aligned, and have in-depth conversations with those you borrow money from, especially when doing unconventional deals,” Dee said. “If things go south, you want to ensure you know who you’re doing business with, that they are focused on solutions, and that their emotions don’t run the show.”

Record all agreements — including terms and conditions of the loan, percentage of ownership of the asset and responsibilities — in a legal contract. It’s wise to hire a lawyer for this step, even if your investing partner is a close friend or family member.

Cash-Flowing Assets You Can Buy With a Loan

Small businesses: Buying a business can be a lucrative endeavor, said Tallou, especially if you can cut costs by outsourcing work at a cheaper rate, buying more effective machinery or implementing automation tools.

Real estate: Real estate investors often use conventional mortgages, HELOCs, home equity loans or hard money loans to purchase properties and rent them out or to renovate older homes and sell them at a profit.

Book of business: If you’re already a business owner, you may want to see whether any other businesses in your industry are planning to sell their client lists.

“There are CPAs, insurance practices and financial advisors who are looking to retire or exit their respective industry and want a lump sum buyout for their book of business,” Tallou said. “If the revenue exceeds the payback, it’s worth exploring.”

Websites or online businesses: “Most people don’t realize you can buy a website, but I’ve found that it’s a great way to use debt to buy an asset,” Kovar said. “With just a little bit of knowledge, you can buy a cash-flowing website or online business that allows you to work from anywhere.”

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This article originally appeared on How To Use Debt To Build Wealth