The difference between personal finance and business finance

There are a lot of tactics that work well in both the personal finance world and the business world. Cutting your spending works in both worlds if you do it in an intelligent way. Investing in resources that will last for a long time is a good tactic in both worlds.

However, there are things that work in business finance that don’t really work in personal finance.

The biggest one, from my perspective, is the concept of leverage. Leverage, for those unaware, refers to any technique that can be used to multiply gains – but, if it fails, it also multiplies losses. Examples of leverage include borrowing money and using derivatives.

Here’s an example of what I’m talking about. Let’s say you borrow $1,000 with the intent of putting it in the stock market. You put $1,000 of your own money with it and invest it in stocks. 

If the stocks go up 20%, you’ve made $400. You can pay back that $1,000 you borrowed and you still have $400. You’ve managed to make a 40% return.

At the same time, if the stocks go down 20%, your stocks are now worth only $1,600. You have to pay back that $1,000, so you’re left with $600. You took a 40% loss. (We’re not even talking about any potential interest on that loan, either.)

If you make money with leverage, your gains are multiplied. If you lose money with leverage, your losses are multiplied.

In the business world, there are many situations where leverage makes sense. Most companies use leverage at some point to either build their businesses up rapidly or increase their profit margin.

Here’s the big secret: if leverage fails in the business world, people can (usually) still go home to their house. They can still drive their car. They can still live the life that they’ve built.

On the other hand, if you use leverage in your personal life and it fails, you lose a lot of those things.People that you owe money to personally will come after your assets. If you’ve leveraged your home (via a mortgage) and can’t pay the bills, they’ll repossess your home. If you’ve leveraged your cars (via a car loan) and can’t pay the bills, they’ll repossess your car.

Within a business, leverage has a tremendously nice upside. If you’re able to borrow money, that means you can get by with a smaller investment in that business – and if you turn a profit, that means the ratio between your investment and the profit you make is much larger. Your percentage profit can be enormous thanks to leverage.

In personal life, most of the things you purchase for your life aren’t there to turn a profit. You might earn a small return on your home, but the days of the housing bubble are over. Virtually everything else you buy, from your car to your home entertainment equipment, is going to rapidly go down in value. From a purely financial perspective, most of the things you spend significant money on in your personal life are terrible investment.

So, in business, leverage has a potentially great upside and the consequences of the downside have limited effect on your personal life. In personal life, leverage doesn’t have that big of an upside and has a potentially strong negative effect on your personal life.

That’s why I don’t trust people who suggest that others use leverage in their personal life. If someone suggests that you personally borrow money in an effort to make more money, I suggest walking away from that idea.

If you really want to borrow money with the goal of making a profit from it, start a business and have that business borrow that money. Set up the business so you have minimal personal liability.

Don’t ever risk your personal situation to chase a dream of getting rich. Don’t take on personal debt in a pure effort to make more money. In fact, avoid personal debt entirely.

The post A Big Difference Between Personal Finance and Business Finance appeared first on The Simple Dollar.