Investing in Debt – The Slow Approach to Wealth

benjamin franklin
"It’s common to believe that credit agreements are just the lender’s and borrower’s business but the truth is far more complex than that, if you’ve ever made a credit request, especially from a well-established bank or corporation, chances are that other individuals and entities are pocketing money from your loan, several banks and creditors are only able to loan money because they also borrow money."

To be clear, this is not a guide on how to invest when you’re in debt, it’s an insight into how to profit by investing in third parties debt.

Investments come in all shapes and forms but pretty much all of them fall under the same principles, they are either ownership investments (ex: stakes at a company) or loan investments (ex: debt instruments).

Small businesses or startups typically have a hard time when it comes to borrowing, well established banks and credit unions will promptly deny any requests of small nature, there are a few reasons why:

   > Small businesses usually request small loans, which means small profits.

   > Small businesses lack market maturity, therefore the borrower defaulting risk is higher.

   > Most small businesses have a poor credit history.

These are just a few factors, loans could be denied for several reasons more.

With this accounted for, borrowers tend to take alternate routes to obtain desired funds, this is where private lending shines.

1- How Private Lending Works?

Private lending is when an individual or small business without any ties to credit unions or banks loans personal funds to a borrower, this practice covers all sorts of loans but it’s most commonly used among personal or real estate loans.

Let’s say you’re a private lender for a real estate investor, the same principle of credit unions and banks is applied but in a smaller and less regulated way, the investor gets the property and you get a passive return on investment unless you specifically agreed with the borrower to be a participant on property management as well.

Return on Investment calculation

Even though this won’t make you instantly rich (pretty much nothing will), it’s a guaranteed way of passively accumulating profit over time if you’re in possession of money just resting on your account.

Are You Qualified for Private Lending?

The good news is that anyone with enough capital can be a private lender, the bad news is that it also takes some knowledge of what you’re investing in and what are the risks involved.

Understanding what you are in for is just the beginning, the project must be immediately presented in a clear way, if the borrower is not someone you know personally, make sure that his vision aligns with yours and that the project makes sense, the money you’re about to “park” will be tied to the project for a long time so make sure every step you take is as right as it can be.

Since private lending is not standardized, there’s a good chance of the borrower defaulting, once in that unwanted scenario, you can secure the collateral through foreclosure.

How to Become a Private Lender?

Ok, so you’ve got the capital but how do you connect with borrowers?

Prosper and Lending Club are both peer-to-peer platforms and great places to connect lenders with borrowers.

Account Eligibility

Here are the requirements to join both platforms:

Prosper

   > You must be 18 years of age or older.

   > You must reside in an eligible state.

   > Some states require a minimum amount.

Lending Club

   > 18 years old of age or older.

   > You must be a US citizen.

   > Have a credit score of 600 or higher.

   > Debt-to-income ratio under 31%.

Is Private Lending Profitable?

This question can be answered by your wealth and patience, ownership investments tend to be more lucrative in the shorter term if you don’t want to spend the time waiting around.

Private lending is best suited for you if:

   > You have a considerable amount of money with no plans of spending it in the near future.

   > You have a consistently high income.

   > You own a successful company.

   > You’re retired and looking for passive income.

   > You’re a real estate investor.

2 – Investing in Bonds

Bonds are debt instruments, they’re a way of raising money for the bond issuer by selling IOUs, they can be issued by the government, banks, or corporations.

By buying a bond, you are loaning money to the bond issuer, they agree to pay you back the loaned amount on a specific date and make interest payments to you along the way until the bond matures, at that point, you get repaid the initial invested value, interest rate payments on bonds typically occur once or twice a year.

If you’ve read the previous subject, you may notice that bonds and private lending are very similar, to answer your questions, the difference between both is that bonds are highly tradeable.

Believe it or not, the bond market is bigger than the stock market, central banks can set the price of credit in the economy by conducting monetary policy in bond markets, when central banks buy bonds, money flows from the central bank to individual banks, therefore, the money supply in the economy increases, when they sell bonds, money flows the other way around, from individual banks to central banks, decreasing the money quantity in the economy.

The reason why bonds are traded by investors is to increase yield in their portfolio (yield is the expected return after holding a bond until maturity), investors trade bonds by selling lower-yielding bonds and acquiring similarly rated bonds yielding higher.

Bonds Vs. Stocks

Unlike equity purchases (ex: stocks), bonds give you no ownership rights, this is both good and bad, good because you don’t have to deal with daily fluctuations and it’s a rather safe investment but at the same time bad because you’re not investing directly in the company, therefore, you won’t be benefited from its growth, the best option is to always keep a diversified portfolio, if you’re into stocks, have a look at the best stocks for 2021 here.

Corporate Bonds

A corporate bond is one that’s issued by a firm and sold to investors, these types of bonds pose a higher risk than government bonds because most of the times they’re not secured by collateral but not everything is bad, by assuming a bigger risk, the investor will receive higher interest rate payments, typically between 5 and 6%.

Government Bonds

These are issued by the government in order to support government spending, this includes, healthcare, roads, welfare payments, and so forth.

Government bonds have the lowest risk, they’re backed up by the government itself, interest rates fall under 1% most of the time.

Mortgage Bonds

As it happens with private lending, holders of mortgage bonds have a claim on the property as secured collateral whenever the borrower defaults, when this happens, bondholders can sell the asset to cover the missing payments, these are also high-risk bonds but with secured collateral.

How to Buy Bonds

Bonds can be bought from a broker or from bond issuing entities like the government, municipalities, or corporations.

U.S Treasury bonds can be bought directly from Treasury Direct, to open an account you must:

   > Be 18 years old of age or over.

   > Have a valid Social Security Number.

   > Have a U.S address.

Other types of bonds can be bought from well-established brokers such as E*Trade or Ameritrade.

Final Thoughts

Debt investing is a powerful tool for any savvy investor that is afraid of taking big risks, while the promise of a passive fixed income sounds good, it requires large amounts of loaned money to make a significant income on interest rates, this is a type of investment that pays off in the long run and one that you should dive into if you are patient enough and want a solid portfolio.

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