the basics #2: debt

En Español

Credit card debt, student loans, car loans, oh my! All of these drum up negative images in our mind. Why? Because we typically go into debt to pay for expensive items that we can't actually afford at the time. This often results in credit card balances that keep growing as the interest on that debt accumulates.

Debt isn't always bad, though. To understand why, it's important to know the difference between consumer debt and company / corporate debt.

  • Consumer debt is what was just mentioned - charging things to credit cards or taking out loans to pay for expensive items. These items are often material things whose value will only depreciate, or go down, over time.
  • Corporate debt, on the other hand, is when a company takes out a loan or issues bonds to pay for business initiatives. They invest that money in new factories, new technology, and new people. Sometimes they even use debt to acquire, or buy, smaller players or competitors. What do companies hope to achieve by doing these things? GROWTH.

"How can you grow by going into debt?" you might ask. It's actually pretty simple. Let me explain. 

As mentioned in the video, you want to move your cake business from your garage into your own store. However, you don't have $50k to pay for the store front. One way you can finance, or pay for, the store is by taking out a loan. How would a loan help you make more money in the long run? 

  • Let's say a bank is willing to give you $50k via a five-year loan. In this case, rather than writing a big check for the full $50k upfront, you would instead break that $50k up into smaller monthly payments over the next five years. You would also owe interest on top.
    • Interest is the fee that banks charge for loaning you money. 
    • A loan's maturity date is the day the loan has to be paid back. 
  • Having the store would increase your customer base tremendously. Because more people would buy cakes from you, your sales would grow, and so would your profit. If, over the five years, you're able to generate more in profit than you pay in interest and the loan itself, then taking out a loan to pay for the store would be a good investment.
  • The beauty of it, too, is that once you pay the bank back, the store is yours to keep! As is the higher annual profit. 

To recap, using debt to finance the store would be a good investment if:

the increased profit you make from it over time > the amount of the loan + interest

 

< < < Previous                              Next > > >