With interest rates having been at historic lows for a number of years, attitudes toward debt have changed. That’s because there’s a view that interest rates will remain at their current levels indefinitely and that individuals and businesses can get away with borrowing huge sums of money without running the risk of running into trouble.
Of course, borrowing money can help to generate profits. After all, if the rate of return is higher than the rate of interest then the difference is pure profit. However, with interest rates set to rise at some point, the difference between the two figures is likely to narrow and may even turn negative. This could leave individuals who have borrowed to invest in a very challenging situation and they could lose out financially as a result.
This risk of borrowing is often overlooked and yet is a key consideration for anyone taking out any kind of loan. As Warren Buffett famously said: “If you’re good enough you don’t need leverage. And if you’re not good enough, then you shouldn’t use leverage.” Furthermore, borrowing during boom periods can be beneficial while asset prices are rising. But during periods of either tightening monetary policy (which is likely in the coming years) or bust periods (which can’t be ruled out moving forward), borrowings can be a huge and very costly problem.
Why borrow when there are better alternatives?
To make a million you don’t need to borrow a single penny. Yes, it could be argued that you will reach a seven-figure portfolio faster if you borrow. This may be true during a boom period, yet the reality is that a long-term investment horizon is likely to include a range of economic scenarios. Investing cold, hard cash and letting the stock market and compound interest work their magic seems to be the best move for most investors.
After all, the FTSE 100 has returned over 9% per annum in the last 32 years. That’s a superb rate of return and beats most other asset classes over that time period. And when such a rate is applied to even a relatively modest amount of money which is dripped into the market, the results can be astounding.
Take for example a 30-year-old who has no retirement portfolio. He/she begins investing 20% of their take-home pay each year, which given the average annual pay in the UK of £27,000 equates to around £4,300 per year. Investing that amount every year for 37 years (i.e. until the age of 67, which will be the retirement age for men and women from 2026 onwards) will lead to a total figure of over £1.1m by the end of the period.
Such a figure isn’t beyond the reach of the vast majority of people. As such, it’s possible for anyone to put away a sensible proportion of their income each year and generate a £1m-plus portfolio without needing to borrow any money.