The Debt Benefits

There are many points of view when you want more information about the benefits of debt. You may want to know more about the debt benefits in:

  • General Economics

The benefit that a debt can bring to an economy, and how it can help the economy to grow at a higher rate. In a general way debt is a way to create money and the banks are essential for this.

  • Firms

Debt is a resource that can be used to buy additional assets, without adding money from equity. It is a way to leverage the firm.

  • Investors

The use of debt can cause a change in the taxes paid, it can decrease the amount of taxation. The explanation for that cause is the relation between taxes and debt, if there is a debt, you have to pay interest, so the profit will be lower and the taxes paid will also be lower. The winner of this decrease in tax can be the investor, if the investor was the one who lent to the company.

  • Government

The government debt is a big concern nowadays, it is how the government finances its deficits and a way to spend more than the taxes received. Governments usually use deficits to help the economy grow, spending more on the economy than the money they take (taxes).

The effect of Debt

The growing effect of debt
The growing effect of debt
Credit Cards - Money you cannot see and does not exists, but you can use it.
Credit Cards - Money you cannot see and does not exists, but you can use it.

The Debt Benefits in Economics

In a basic economy money has to start somewhere, normally at the central bank, and the central bank can issue money. So if the central bank issues 100.000, let's say imaginary dollars ($), the economy has a total of 100.000 $ for trading.

In this basic economy people can deposit money in banks and banks can lend money to other people, they just have to have a reserve funding of 20% (which is a large number in nowadays economy). So if the bank has deposits on the amount of 50.000$, it can lend 40.000$, this debt that people will take will create an additional 40.000$ on the economy, since now you will have:

  • 50.000$ circulating
  • 50.000$ deposits of people
  • 40.000$ circulating by people that borrowed

That makes a total of 140.000$, since the 10.000$ reserved are part of the deposits. The other $40.000 are being used by people who probably wanted to invest but had no money, the idea is that in the future they will pay their loans and the economy would get back to $100.000.

The basic idea is, Debt can generate Growth.

The Debt Benefits for Firms

Firms are made by three simple things, Debt, Equity and Assets. In order to buy assets and operate, the firm can appeal resources in Equity (Own money) or Debt (Ask a third party for money, normally banks.),

The firm that uses debt will have the possibility to buy assets above their initial limitations and that can be a big help to begin operations, if the company could not use debt it would have to save its profits in order to further investments. Using debt, the company will receive money to do the investments and after they have to make the repayments to pay off the debt.

Debt benefits for an investor.
Debt benefits for an investor.

The Debt Benefits for Investors

In most countries there are taxes for the firms and for the people, in this case the investors. The profit tax is used for firms, it is a percentage of the firm profit. The Income tax is used to tax the revenue that the investor gets from dividends or other forms of income.

An example of two similar companies, one with debt (Company A), the other has no debt (Company B). Both have revenues of 10.000$ and fixed expenses of 8.000$, so they will profit 2.000$, assuming a tax of 25%, companies would pay 500$ (25% of 2.000$).

However company A has a debt that was contracted with the investor to finance the operating expenses and has to pay 1.000$ in interests to the investor, the 1.000$ will be considered an extra expense and the profit will be 1.000$, so the taxes paid will be 250$ (25%*1.000$).

Assuming the Income tax is 20%, the investor had the option to invest in A (using a debt situation) or B (using equity). In this simple example the difference between using Equity or Debt will not be considered.

Company A: Investor receives 1.750$ (1.000$ in interests and 750$ in dividends) and pays 20% tax. Ending with 1.400$.

Company B: Investor receives 1.500$ in dividends and pays 20% tax. Ending with 1.300$.

Example of Gov. Debt Benefits

A simple example, with Gov A & B. Both have growing rates of 2%, inflation of 2%, a GDP of $100 and taxes and expenditures of 30%.

However Gov B decides to take a loan to boost economic growth. If the Gov. can boost the growing rate to 4% with a loan of $20 (20% of GDP) and the interests are 2% of GDP with repayment after 10%, we have the following data.

Benefit of Gov. Debt.  - After 10 years there is still a surplus.
Benefit of Gov. Debt. - After 10 years there is still a surplus.
Comparison of GDP with and without debt (Simple Example)
Comparison of GDP with and without debt (Simple Example)

The Debts Benefits for the Government

Governments receive taxes and then there are several items in which the money can be spent. From expenditures in defense to healthcare for the citizens. Sometimes taxes are not enough to pay all the expenditures, so the government will register a deficit and will have to ask for money to pay their obligations, the way to get more money is by raising taxes or getting into debt, since raising taxes is unpopular, debt is the solution.

There are benefits for the citizens and the government to get into a debt situation, it makes possible for the government to invest more than the taxes received and that way help to increase the economy, maintaining good levels of growth.In theory the economy growth will help to pay off the debt, since this economic growth will generate more taxes (same rate taxing a bigger economy), the theory is that in the future the debt will be paid off by the own effects.

An example can be a country with no money and impossible to raise even more taxation, but in a desperate need of infrastructures like a port, railways, roads or an airport, if the government could invest in such projects, the economy would grow because the industry and commerce of the country would benefit of being connected with the rest of the world and connected in a faster way. Debt would be a good solution if the interest was lower than the future growth rate, that is a sustainable growth rate.

Benefits of paying off debt

There are many benefits in having debt, but all good things come to an end, and so debt has to be paid off. You may want to pay it off in the end of the term or before, the reason to end the loan before the expected may have its benefits.

The main benefit is the end of the payment of interests. If you have money enough to pay off the debts you have two main choices:

  • Pay off the debt
  • Invest the money in another project.

Your choice will probably depend on the rate, the interest rate of the debt and the return rate you can get by investing the money. The higher rate will probably be your choice, it will be the option that will give a better value for your money in the future.

Example, If you have $100.000 cash, a $100k debt, an interest rate of 10% and a project with a return rate of 5%. After 1 year you can have the following scenarios.

  • Pay off Debt - $0 Cash , $0 Debt, $0 Result.
  • Invest in Project - $0 Cash, $100k debt, $10k to pay in interest, $5k returned from investment. Losing $5k per year.

If you have 15% return rate you will be gaining $5k per year. The higher rate wins.

What if you have same rate for Investment and Debt

You have $100k that you can either invest or pay a debt of $100. Both rates are 10%.

If you decide to invest, by the end of every year you will have $10k of return because of the investment, but you will have to use that $10k to pay for the $10k in interests. By the end of the year you will be the same that in the beginning.

Paying off the debt has the benefit of ending future payments to the bank and ending any problem you can have in the future because of an interest change rate or if you want a cleaner Balance Sheet.

Interesting Comparison between debt and a glass of water

The US debt explained

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