Making Debt Work for Business
Royal Bank of Canada - Definitive Guides
Can debt be useful to a small business owner?
Debt can be invaluable when used for mortgages, capital, equipment loans and operating lines. Understanding some of the options available, and picking the right ones, can sometimes make the difference between business success or failure.
What is “good” debt?
“Good” debt finances productive assets or assets that appreciate in value. Using a mortgage to buy a house is a classic example of “good” debt.
What is “bad” debt?
“Bad” debt is any debt you can’t afford. It carries high interest rates, and finances things you could go without. Undisciplined use of credit cards, for example, could lead you into “bad” debt.
How do I as a small business owner make debt work for me?
Borrowing money to fund business operations or buy capital assets for business use can be a shrewd move. While your business benefits from having operating capital or a new piece of equipment, you get to deduct the interest costs from your taxable income.
Because interest is deductible when used to borrow funds for earning income, many people turn to “cash damming”. What does that mean? Say you’re a sole proprietor of a business with a $100,000 home mortgage and $100,000 in business income. One option is to use the business income to pay for business expenses. But it can make more sense to use the income to pay off the mortgage, and get a home equity loan (i.e. using your house as security) to finance the business expenses.
Why? Because with an investment or operating loan, the interest is tax deductible; it isn’t on a mortgage used to purchase your home. Basically, you use the equity to buy assets that aren’t used for income-earning activity, and buy income-earning assets with the borrowed money.
What is leveraged investing?
Another useful strategy to make debt work for you, especially in light of low interest rates, is borrowing to invest, known as leveraged investing. Leveraging makes sense when:
- You have a long term plan – enough time for the investment to grow beyond the loan amount plus interest costs.
- You invest rather than speculate, concentrating on investments that pay interest, dividends and trust income, to get compounding working for you.
- You diversify your portfolio, distributing investment risk among equities, fixed-income and cash.
- You have surplus cash flow, with the ability to cover increased interest costs down the road.
Cautious and prudent leveraging can accelerate asset growth – but you must make sure that you understand, and can afford, the risk.
When can debt be a sound financial tool?
In the business world or in your personal life, debt used in appropriate amounts, for appropriate purposes, depending on your circumstances, can be a sound financial tool.