Debt: The Introduction
Debt is without question the most controversial subject in personal finance and for good reason too. As we all know, debt is a powerful financial tool with the ability to catapult us into wealth, or simultaneously drag us down into financial misery.
With this in mind, lets dig into the topic a little and find out just what makes debt so good, so bad, and so ugly. Maybe with a bit of knowledge and skill we can tame this wild beast for our benefit.
The Difference Maker
Debt: The Good
Let’s review some good uses of debt and see if we can notice a pattern.
Education
Education is so important nothing should stop a motivated individual from pursuing higher learning. Of course, this includes lack of funds, and so borrowing money to get educated is a good use of debt. The importance of education cannot be overstated, but here are some points to ponder. Firstly, it increases your earning power by an astonishing 70% compared to a worker with a high school diploma; and this benefit is realized each and every year of your working life. Secondly, it permits you to pursue a career that aligns to your interests and passions. Thirdly, it increases your critical thinking, ability to evaluate consequences, think long term, and make better overall decisions. Lastly, it provides a sense of accomplishment because achieving such an education is difficult and takes years.
From personal experience, I can say I spent $22,500 getting my Bachelor’s of Commerce degree over the course of 3.5 years. Leaving university, I was hired immediately into my field of choice and my first job paid me $42,000 annually. It’s an investment that has paid itself time and again over the last 18 years.
Rental Property
Next to education, another good use of debt for building wealth is buying an investment or rental property. So long as you don’t take on too much debt to purchase the property, and can make it positive cash flow, rentals are terrific investments. It is no coincidence that real estate has minted more millionaires than any other asset class, and rentals are the common method deployed.
Leveraged real estate is relatively low risk, especially if you buy in a good location and keep the debt servicing ratio within reason. Fully leveraged is not a good idea and will make it very difficult to make it cash flow positive from the start. Also, remember your total cost of ownership for the property and you will need to put a few thousand aside each year for maintenance.
If this is something you’re interested in pursuing further, read this blog post here which includes a detailed spreadsheet for evaluating the revenue and costs.
Using Leverage on Income Generating Stocks
Investors not interested in managing a physical asset like real estate, but still want leveraged income, should consider dividend paying stocks. Borrowing, or investing on margin, with such equities can be a great way to increase our income. On top of this, there is the potential to earn substantial capital appreciation as well.
However, with this strategy comes increased risks and volatility not usually seen with real estate. Keep in mind we are talking about adding risk to an asset class historically known for risk and volatility. As we know, some investors can’t stomach the volatility that comes with fully owned stocks. If this is your case, then skip this strategy altogether and favor real estate, additional education, or skip debt altogether.
Regardless, take care not to over do it in this area. So, if you’re going to pursue this investment approach, try to keep your borrowed amount to less than 30% of the portfolio total value.
On the positive side, the income from the dividend stocks can service the debt, and even reduce the outstanding balance. What this means, is over a period of 10-20 years the investment could deleverage itself and you end up with a fully owned portfolio income generating equities.
In summary, if you can stomach the volatility and have a 10-20 year time horizon, leveraged dividend paying stocks can be a fruitful strategy.
Business or Partnership
The last good use of debt is also the most risky but most rewarding. Depending on your opportunities and business acumen, you can use debt to accelerate your business. Some capital intensive industries will likely require debt to finance the initial operation and get things off the ground. These opportunities are unique in that performance and result of the operations can largely fall within your control. This allows the risks and issues to be mitigated through your skill, knowledge and experience.
Debt: The Bad
The quote above is true regardless if the debt is good or bad. Every time we borrow or take out a loan we should realize that we are robbing our future self of this income. Therefore, ask yourself if it is worth it. In the case of the good uses outlined above, yes, it is likely worth it. Now, let’s change our focus and look at some bad uses of debt. While some may not be entirely avoidable, we should try our best to lessen the burden when possible.
Vehicle loan
A vehicle is a terrific tool that gets us from point A to point B and are often used daily for work. Additionally, some help us create lasting memories with our family. Road trips, camping, exploring, sports, racing, the list goes on. In many ways vehicles add terrific value to our lives. However, the truth is they depreciate in value and are worth much less after five years and some nearly useless after ten; they simply wear out.
In some cases, the loan used to buy these wonderful machines will last longer than the useful life of the car. When this happens you can really be put behind the curve and truly rob your future self.
Always consider the opportunity cost and what you will not afford when buying an expensive car which requires a heavy loan.
Christmas / Holiday shopping
Another western favorite is to buy heavy on the credit card during the Christmas season. Many families require the incomes from January and February to pay off the balance. The cold fact of the matter is very often the trinkets and toys are rarely used past March, while some don’t even see use past the New Year. If you’re going to borrow to make Christmas special, just try and make sure you’re buying stuff that will last until at least next Christmas.
Vacation
Another bad use of debt is taking out a loan to finance a vacation. While the memories may last a lifetime, if this puts you into a financial hardship, the fiscal burden may last just as long. On top of this, when you return, you have nothing tangible which could be sold if you need to pay off the loan faster.
Home Mortgage
A mortgage for our primary or principle residence is not the worst form of debt, but it is certainly not a good use of debt. While unavoidable for most, a home mortgage needs to be managed and the burden reduced. Our homes are not an ATM from which we pull out equity to finance our lifestyle and bad spending habits. Even in the best scenario, a mortgage still requires a significant portion of our monthly income and produces no income for us. On top of this, the maintenance, property taxes and HOA fees can make home ownership a true burden. We’ve all heard the saying, “House poor”,
Remember the word mortgage means a, “Death Pledge” or an, “Agreement until Death”.
Home Renovation Loan
Building on the last, a loan used to finance a home renovation is a poor use of debt because you will never get back what you spend. You are literally spending dollars that are immediately worth $0.50 to $0.80 max. Keep in mind we’re talking about our primary residence and not an investment property. The investment property could turn it into a good use of debt if it increases our monthly revenue.
Debt Consolidation Loans
Another tricky one on our list of bad debt are debt consolidation loans. While these loans can be effective in lowering our monthly payments and total interest costs, they often do not solve the root of the problem. What’s worst they often secure the loan against your home and effectively reload your capacity to spend recklessly again.
If you can keep the loan unsecured, and change your spending habits, then yes, this is a good form of debt. However, we often see “spending relapse” and we’re back where we started in a year or two.
Tax Refund Loans
In today’s age of filing your taxes online with direct deposit, there is no need to pay a third party a substantial fee so you can get your tax refund sooner. Your tax refund will come in a week or two and your credit card likely has a lower interest rate than you’re paying for this service.
Debt: The Ugly
Next, we take a look at the worst form of debt; the horror house of financial ruin. These are the worst forms of debt and should be avoided at all cost. The problem with them is not only the high interest rate, but they are geared to induce more debt and trap you into a continual cycle of debt and interest payments.
Credit cards
Should come as no surprise that the first on our hit list is credit card debt. Firstly, the biggest problem with this debt is that it is so accessible and so easy to get in over our heads. Secondly, the minimum payment is absolutely criminal, it absolutely feeds the beast and encourages a cycle of continual debt and interest payments if followed.
Check out the infographic below outlining just how long and how much interest you will pay if you only make the minimum payment each month. ThePennyHoarder.com has more details and information about this very toxic form of debt.
Payday loans
Next on our downward spiral is the nefarious payday loan. Simply put, avoid these at all costs; reach out to family and friends first before resorting to these types of loans. They encourage a constant cycle of debt, interest and stringing yourself out to the point of not even making it to your next pay check.
If this is your last resort, please reach out to a credit counseling service or equivalent to explore other options. Likely, there are other factors at play making it difficult to reach meaningful financial goals. Once you know the reason you’re resorting to these types of loans, you can remedy the problem and get yourself back on track.
Payday loans are a massive red flag you’re off track financially and in need of assistance.
Gambling or betting with borrowed money
On the second to last rung on the ugly debt ladder is gambling or betting with borrowed money. This is guaranteed to end in ruin and tears. Notice I didn’t say maybe, or possibly, as it is a guarantee. The law of large numbers means over time, the odds are against you and the house, or casino, will win in the end. What this means is you will eventually lose it all and then also all the money you owe too.
Never borrow to bet.
Mobster Loans
Now, at the bottom of the spectrum of useful debt is the worst kind. We’re talking the kind of debt that can cost you your life. Never under any circumstance get yourself into debt with a gang, mob, or organized crime.
The Debt Spectrum
A Gift From the Future
While it is true, when you borrow money you rob income from your future self, it does not necessarily mean it is wrong. Certainly, most, if not all bankruptcies involve high levels of debt. However, it only means the debt was used incorrectly on a good or item that has no residual value now. For if it could be sold, it would, and the debt retired.
Think of it like this, if you could send money backwards in time to your younger self, with a penalty of 50%, what would you buy? In other words, at the cost of $10,000, would you send $5,000 backwards in time to your younger self with instructions on how to use it? Of course, you would, and give instructions to buy Apple stock, Bitcoin, or equivalent asset.
Now of course, we don’t have the benefit of hindsight or time travel. However, we can use prudence and probability to guide our choices and make the best decision possible. I think property, education, and dividend stocks are your best bet when using of debt.
Conclusion
In summary, look at debt as a gift from your future self. Make the best use of it and treat it with respect. Keep in mind that in most cases debt is not required to build wealth as you can save and invest your way to financial success. However in the cases of education, or a rental property, debt can be an effective tool for building wealth and easily justified. In other cases, debt is required to buy a home or get the car you require. In such cases, prudence with these forms of debt is a good idea so the burden properly managed. Don’t let the opportunity cost of a house and car rob your future self of the wealth it deserves.
You do not require debt to become wealthy and a financial success story.
— Stephen Wealthy (@mywealthmoney) March 16, 2021
But you will need debt if you want to become a financial disaster resulting in bankruptcy.
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