How the Rich Use Debt Differently — and What You Can Learn From It
Written by
Dawn Allcot
Edited by
Jenna Klaverweiden
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If you’ve watched financial experts like Suze Orman or Dave Ramsey, you already know that most debt is “bad,” or, at least, something to be avoided because it can keep you from achieving your financial goals.
But then Elon Musk regularly borrows against his massive stockpile of Tesla shares to support his other businesses. It’s a common practice among the ultra-wealthy. But how does it work — and can the middle class leverage debt in healthy ways too?
Middle Class vs. Wealthy Debt
The ways the middle class and the wealthy view debt are inherently different. “Most regular people use debt to consume things that depreciate: cars, clothes, vacations,” said Kevin Reed, chief revenue officer at Aquilance. “Debt is a survival or consumption tool.”
This is especially true today, when 52% of consumers reported using credit cards and other forms of unsecured debt to buy groceries and household expenses, according to a PYMNTS survey. Wealthy investors, on the other hand, frequently borrow against their stocks and other assets to fund moneymaking endeavors, such as buying real estate or investing in another business.
“More financially sophisticated individuals use debt to acquire or retain assets: stocks, real estate, businesses, etc.,” Reed said. “Debt is a tool for liquidity and tax deferral, which allows them to grow wealth.”
Holding On to Investments
Not only do the wealthy borrow to pay for things that will make them more money, but they do it at low interest rates because of the tremendous amount of collateral they hold.
“The most common strategy is to take loans out against appreciated stock or other assets, rather than selling the assets themselves to generate cash,” said Bill Harris, Evergreen Wealth founder and CEO.
Borrowing against investments, rather than selling them to free up cash, has a few benefits. First, it can avoid the capital gains tax you’d pay by selling the stocks. Plus, Harris said, for people like Musk who hold majority shares in the company, “They avoid diluting their ownership position in the company or asset.”
‘Buy, Borrow, Die’
Harris summarized one of the ways wealthy individuals look at investments and debt. “A classic strategy is ‘Buy, Borrow, Die.’ Buy stocks and don’t sell as they appreciate, borrow against them for cash needs, and avoid paying capital gains tax on the appreciation when you die,” he said.
The last element preserves generational wealth because of a tax law known as “stepped-up basis.”
Under the law, the cost basis of inherited assets increases to fair market value at the date of the owner’s death. If the heir sells the stock, they don’t have to pay capital gains tax based on the original purchase price of the stock, but on the market value at the date of the original buyer’s death. If they decide to sell immediately after transfer, they’d receive the stepped-up value of the stock with no capital gains tax.
Leveraging Stock Positions
Ultra-high-net-worth individuals can borrow against their portfolio for many purposes, including buying more stocks or investment.
Harris explained that borrowing against assets can add leverage to stock positions. “This amplifies the net gains if the stock goes up but also amplifies the net loss if the stock goes down,” he said.
Reed pointed out that many of his clients “borrow when they can get a rate that is lower than the expected return on the investment.” However, this can be risky for middle-class investors with smaller portfolios, especially if those investments are meant to cover retirement.
“Margin loans are used to purchase securities and therefore add leverage to the portfolio — higher risk and higher expected return,” Harris said. “But adding leverage to your investment portfolio increases volatility and risk. It does not make sense to leverage your portfolio until you have assets beyond the amount you need to comfortably retire.”
‘Good Debt’ for the Middle Class
Experts agreed that the middle class should approach any kind of debt with caution. “For the most part, with the exception of a mortgage, middle class families should avoid all forms of borrowing if they can help it,” Harris said.
Reed pointed out that borrowing to fund a proven real estate venture or small business could be worthwhile. “Mortgages where rent covers the payment allow you to build equity and generate free cash flow,” he said.
Any debt represents risk, but being willing to take small, calculated chances on assets that appreciate, tools to increase your income or business ventures with good odds of success can help you build incremental wealth.
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