Return on Investment - How Debt Can be Good!

Return on Investment (ROI) is an important term used throughout the financial and investing world. Understanding ROI is one of the most essential things to learn when dealing with money. Spending less out of pocket (at first) and making more in return is what ROI is all about.

Borrowed money is deferred money. You don’t have to have it right away, so it gives you the leverage to make a purchase if you wouldn’t have been able to do so with cash. The leverage factor is why so many people borrow so much money, though most people who borrow have no idea they are using the leverage in a negative way (as with purchasing a vehicle or a personal home).

As you will see, borrowing the money isn’t really as bad as most people think it is – this is also how financially smart people make their money and keep building it long after they retire. You don't have to have money to make money, contrary to belief.

In the following examples, I'm not saying that paying cash for a car is the way to go, nor am I saying the borrowing money to buy a car is the smart thing to do. The following are just examples to help you understand the concept of ROI. Please read my terms of service for my disclaimer.

This is where most people get lost, so pay attention closely. It's simple math, but it is a very confusing topic.

Example 1 – No Leverage Applied:

Say Jodie buys a car for $1,000 with her own money, paying cash. She waits a year and sells the car for $1,200, essentially making $200 profit on her investment. Her ROI is 20 percent. Pretty simple math (200 divided by 1,000 = .20). And most people are satisfied with the 20 percent return because they didn't have to go into debt to do it. The only problem with this is that your $1,000 investment isn't working as hard for you as it would if you didn't pay cash.

Example 2 –Leverage of Borrowing Applied:

Now Jodie buys a car for $1,000. This time she only pays $100 with her own money and borrows $900 at 20 percent interest. Again, she sells the car for $1,200. How did she do this time? We have the same $200 profit. But now her personal investment is only $100. If you factor in paying interest on the $900 that she borrowed at 20 percent, and it took 6 months this time to sell the car and pay off the $900 loan, plus interest of $90, that would make her total cost $1,090.00. She sold the car for $1,200.00, so her profit was only $110 instead of $200. Yes, she paid more overall for the vehicle, but since she only initially invested $100 of her own money, her return on investment is 110%. Remember, borrowed money is not yours to begin with. Yes, you have to pay it off, but this is a concept known as Leverage of Other People’s Money. If you don’t have enough to pay for it, use other people’s money to pay for it. It gives you the leverage to get what you want with less upfront money out of pocket. That doesn't mean go out and buy a car with other people's money right now. This is just a simplified example so you will understand the concept.

Now, put things in a more realistic perspective and learn how return on investment can make you more money.