How to lend money to a deadbeat friend
Let’s say you have a couple of friends and they each want to borrow money from you. One of them has a great job, and the other always seems to have some kind of issue – he’s always broke, getting fired, and sleeping on friends’ couches because he can’t pay rent. And trust me, we all have a friend like that.
But here they are. They both want to borrow $1,000 from you. It’s probably an easy decision to lend money to your responsible friend, but why would you ever lend money to your deadbeat friend? Because you want to make money!
Here’s how it works.
In the last lesson, you learned about bonds and credit scores, or what we call credit quality. A good credit quality means there is a good chance you will get your money back. A bad credit quality means there is a good chance you won’t get your money back.
There are bonds from companies just like your deadbeat friend. There are companies that might not make a lot of money and might owe a lot of people a lot of money. Bottom line, it’s a company that may struggle to pay you back if anything goes wrong in their business.
Okay, so why buy their bond? Why give a company (or a friend) your hard-earned money when there is a higher chance that they may not be able to pay you back?
What if I said that deadbeat company would pay you more interest?
A lot more interest? A high amount of interest? This is exactly what happens.
You have two companies. One big, stable company like Disney that issues bonds – that is, wants to borrow money from investors.
Everyone knows Disney and knows it’s a big company with lots of cash that will almost definitely pay back the money they borrow. I mean, what are the chances Disney is going to go out of business?
Now, over here, you have Bill the Butcher, Inc. again. Tiny company. Not very much in sales. Very little cash on hand. Lots of debt.
They each want to borrow $1,000 and you lend it to both of them. Why? What would have caused you to lend money to Bill the Butcher?What in the name of all that is good would have possessed you to do this? Why not just loan the full $2,000 to Disney?
It’s the one thing that causes most people to do most things: cold hard cash in the form of interest.
Both bonds from each company are going to pay interest, but which company will have to pay more interest to lure investors to loan them money?
Will it be Mickey? Come on! This is Disney we’re talking about. They know they are Disney. They know we know they are Disney. They know they have a great credit quality. If they want to borrow$1,000, they don’t need to entice people by paying a lot of interest. They might pay just 5% interest on their bond.
“High yield bonds have high interest rates and a higher chance you won’t get your money back.”
Fair enough. So if you have a big stable company like Disney willing to pay 5% interest, what kind of interest rate will Billy have to pay?4%? Of course not! It has to be higher. Much higher. I mean a lot, lot, lot higher. Probably 10% or maybe 12%. Now that’s a high interest rate. In the financial world, this is called a high yield bond. Yield just means interest rate. So high yield bonds are those that pay a high interest rate. Why pay a high interest rate? Because no one would lend them money by buying their bonds if they didn’t pay a high interest rate.
What’s the takeaway?
The takeaway is that it might make sense to lend money to companies that don’t have great credit because you will get a much higher interest rate. High yield bonds have high interest rates and a higher chance you won’t get your money back.
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.