HMSM #03: - How do the rich use debt to create and build wealth?

Financial planners and experts make millions by advising people on how to invest and build wealth. Much of this financial expertise is supported by complicated charts, metrics, and analyses designed to identify the best funds for investment. While financial experts market this advice to the public, the rich use debt to build wealth, supercharging even mediocre investments into great ones.

This discrepancy in knowledge between the rich and everyone else has contributed to an ever-growing wealth divide among individuals. It’s also a key factor in the increasing gap between large companies and small businesses.

The premise is simple: trade something abundant that decreases in value over time for something scarce that will increase in value over time. As a child, I understood this concept. If I had lots of the same Pokémon card, I would deliver my best sales pitch to convince friends to trade their shiny, rare card for my common one. I instinctively knew that the common cards were less valuable than the rare, shiny ones.

In my adult life, however, I forgot this obvious fact and did what everyone else does - avoid debt at all costs and save as much money as I could. The rich did the exact opposite.

According to the Bank of England’s inflation calculator, the supply of the British pound has increased by an average of 4% per year over the last 100 years. This means that, on average, the pound lost 4% of its purchasing power annually because it became less scarce than other assets, goods and services.

When someone borrows pounds to purchase an investment (such as a business, commodity or property), they are effectively borrowing an abundant currency that grows in supply every year to buy something scarcer than that currency. As the asset increases in value due to inflation, the borrowed money decreases in real value (up to 4% annually), and the borrower profits from the difference.

People might find it odd that billionaire tech moguls still have mortgages on their properties. The assumption is that you would want to pay off a mortgage as quickly as possible if you had the means to do so. Yet, the rich do not follow this approach. Instead, they use debt to purchase their assets because:

• The value of borrowed money decreases over time. Therefore, as the investor repays the debt with money each year, they are paying it back with money that is worth less than when they originally borrowed it. This means that in the future, they'll be repaying the debt with "cheaper" pounds, making it easier to repay.

• However, the value of the asset increases over time (when priced in the inflating money). This means that they effectively profit from the asset appreciation and the declining real value of their debt without doing anything at all other than waiting.

• Therefore, they can grow their net worth without investing much of their own money. Instead of purchasing fewer assets outright, they can acquire more assets by using debt, knowing that the value of the debt will eventually become negligible while the assets continue to appreciate in value.

One of the best examples of the power of debt in action is the UK’s homeowning class. Many people know someone who bought a home with a small mortgage (i.e., debt) years ago. Over time, as the value of the house increased in pounds, the homeowner's equity grew to tens or even hundreds of thousands of pounds. While the value of the mortgage or outstanding debt remained the same, the homeowner's wealth increased significantly due to the property’s appreciation. In essence, they borrowed a currency that depreciated in value to buy an asset that became more valuable over time.

This scenario is common for many who get on the ‘housing ladder.’ By using debt in the form of a mortgage, they rely on inflation to increase the property’s value, while their debt remains static. Over time, these homeowners accumulate more equity in their homes. They can then remortgage or refinance to access this equity tax-free, as debt is not taxed. This equity can be used for a larger deposit on another property, restarting the cycle, or invested in other assets like buy-to-let properties.

One problem with this system is that houses have increasingly become investment vehicles rather than homes. Investors can put down a 25% deposit on their first property, borrow the rest with a mortgage, wait for inflation to increase the property’s value, and then use the equity as a deposit on subsequent investment properties. This cycle can continue indefinitely, allowing them to accumulate multiple properties without needing much of their own money after the initial purchase.

You might be wondering – great, how on earth would I get the funds together for a 25% mortgage deposit? Well, outside of a financial windfall or saving up, some investors start by taking equity from their primary residence via remortgage (i.e., debt) to fund the deposit. Then, they use a buy-to-let mortgage for the remaining 75%. This means that in some cases, 100% of the first investment property is funded by debt. From there, remortgages are used to acquire additional properties.

Unfortunately, this approach has contributed to rising property prices, making it harder for younger generations to enter the market. Whilst many may lay the blame solely on landlords and property investors, they are just exploiting a financial system that has normalised and even rewarded people for taking out more and more debt to buy as many assets as possible.

Interestingly, many people assume that most landlords use capital repayment mortgages, where tenants' rent gradually pays down the mortgage, leaving the landlord with a fully owned property at the end. However, this is not the case for most investors. Approximately 80% of property investors use interest-only mortgages. They understand that they don’t need to pay off the debt because inflation will erode its real value over time while the property appreciates. Meanwhile, tenant rent covers the mortgage payments, and the investor can periodically remortgage to extract equity for further investments. When needed, they can sell the property for profit and clear their debts upon retirement.

Property investors and homeowners aren’t the only ones who utilise our debt-based financial system to grow their wealth. Many businesses also use debt to expand or increase the value of their stock. Reputable businesses with steady income can borrow large sums at low interest rates over several years. They can then use that capital to expand, acquire smaller companies, or buy back their own shares. In all cases, these businesses borrow money that increases in supply annually at low rates and use it to build or purchase business equity, which is scarcer.

A prime example is Apple (AAPL), which in 2013 began taking out over $108 billion in debt at low interest rates to buy back its own shares. By June 2024, Apple had become the most profitable company in the world, indicating that they didn’t need debt to grow. Nevertheless, Apple made debt a core part of its business strategy, leveraging the borrowing of a weakening currency to acquire scarcer assets, including its own equity, thus increasing the value of Apple shares for its shareholders.

Those who use debt to their advantage in this way aren’t doing anything particularly remarkable; they simply understand that the value of the money they are borrowing decreases over time. By effectively borrowing money tax-free (as debt is not taxable), they use stronger money today to purchase an asset, then repay the loan with weaker money as time passes. As a result, their net worth does not depreciate due to inflation and can even grow if the borrowed funds are invested wisely. Meanwhile, those who followed conventional wisdom—working hard and saving money—became poorer as inflation eroded the value of their savings and increased the cost of living.

This leads to two important truths: within the current financial system, those who save and avoid borrowing generally lose, while those who borrow to purchase assets that retain value outperform. Over time, the wealth divide between these two groups only grows wider.

TL;DR: The wealthy leverage debt to build wealth by borrowing money at low interest rates, effectively using a depreciating currency to buy appreciating assets like property or shares. This strategy allows them to repay loans with "cheaper" money over time while their assets increase in value, creating a positive spread between the cost of debt and asset appreciation. Meanwhile, those who avoid debt and focus on saving see their purchasing power erode due to inflation, widening the wealth gap between those who understand and exploit the system and those who don't.