You know how people with crummy credit end up paying more to finance most anything, like a car or a house? There are all sorts of subprime lenders specializing in lending to both kinds of borrowers.
Take, for example, Carfinco (TSX:CFN), a Canadian subprime auto lender who is willing to give money to most anyone the dealership rejects. In exchange for lending you a few thousand bucks needed to buy some wheels, they’re going to charge you a pretty high interest rate.
Okay, really high.
Like 2-3%… a month.
At that point, you’ve got to make a decision — just how much do you need that car? If you’re just cruising around the neighborhood trying to pick up the ladies, paying an extra $125 per month (basing it on a $5000 car and 2.5% interest per month) probably isn’t the best idea. Besides, after you pick up the ladies, you’ll have to spend money on them. That is, unless you’re Channing Tatum. Oh my, he’s dreamy. Also, 22 Jump Street was pretty funny.
But what about if you need that car to get to work? Suddenly, the argument starts to make a little more sense. Sure, nobody wants to end up paying thousands more in interest over the life of a loan, but if it costs you $125 a month so you can go to work and earn $3,000, that’s not such a bad option. You’ll obviously want to get a lower interest rate next time, but that’s not really helpful advice when somebody is forced with two options — take the high interest loan or don’t go to work.
In the business world, many different companies have to tap the high yield debt markets. A lot of the time, these companies are struggling, perhaps losing money, and they either need to finance something needed to grow the business, or, most commonly, they need to roll over debt. The previous debt has come due, and creditors want to get paid, but the company doesn’t have the cash. So they need to borrow the money again, this time from new borrowers, and most likely at a higher rate.
In the world of low interest rates and easy credit, these types of situations aren’t really that common anymore. If you’re savvy enough to read this blog and you need a personal loan, chances are you’ve got a few different lenders willing to talk to you, not to mention your friends, who might view you as a good credit risk too.
All this begs the question — why is it acceptable for companies to take out high interest loans while we shun individuals like lepers for doing the same thing?
We’ve talked before how leverage — when used properly — will make you rich. Many people have used debt to buy real estate which appreciated in value, enhancing their returns by doing so. Stock market investors can do the same thing, albeit on a smaller scale. And sometimes, especially when starting a business, people will do the same thing, perhaps by using certain… let’s call them creative forms of financing.
Imagine you were able to buy a business that spins off 25% a year in fairly predictable net profits. No bank will talk to you for whatever reason, so you’re forced to find some creative financing. Maybe you’d apply for a credit card or three with reasonable interest rates. Maybe you’ll borrow from a random investor. Hell, maybe you’ll call up your buddy from the mob and negotiate something without a mob-like interest rate.
If you have confidence in your analysis, it’s silly to lose out on a business that returns 25% a year because you’re scared to take on debt in the 8-12% range. In that case, taking out the loan makes all sorts of sense.
Of course, it’s easy to find the flaw in my logic. Finding a 25% return is difficult to do. Most people take out loans like that to consume, not to invest. Taking out loans to consume is a pretty poor idea. It’s somewhat justified at a 2-3% rate, but certainly not if you start putting numbers in front of that. Consuming is pretty good at destroying wealth on its own. Borrowing to consume just accelerates that process.
Feel free to use leverage from alternative sources to borrow, provided you remember one thing. The investment has to be extra scrutinized, since a higher interest rate adds extra risk. Not all of us are lucky enough to be able to borrow from our parents, or other low interest sources. But that shouldn’t necessarily stop someone from borrowing to invest in an opportunity. You have to be extra careful, but it’s certainly possible. Companies do it all the time.