Myths that Keep You Broke #15

Myth #15 - All Debt is Bad:   

For many of us, the word debt, can be scary and intimidating. But not all debt is created equal. There certainly is high interest and misplaced bad debt. There is even necessary bad debt. However, there is also good debt that can help increase your personal investments. Combining the right kind of debt with paying yourself first, you can build your net worth and ultimately have financial freedom.

First, let’s differentiate between bad debt and good debt. Bad debt is the debt you incur in support of your everyday living. This can be debt from credit cards, car loans or other expenses that roll over from month to month and help subsidize your regular expenses.

On the other hand, good debt has a focus on growth. This is debt you incur to grow an investment. Let me give you an example. Let’s say, you save for years and you purchase an investment property for cash (it can be a house, small apartment building or any other real estate investment). We will use a property valued at $100,000. In this example I will also omit any rental income from the property, or sales commissions, or other expenses and only focus on the appreciation. If in one year the property grows in value by 5% you could sell it for about $105,000. This makes your profit $5,000, or 5%.

Now, if instead of paying all cash for the property, you only invest $30,000 and borrow $70,000 of good debt. Ignore the loan payments, because if you rent it, the tenant is giving you the money for the loan payments. Here is how it would look at the end of the year with the same 5% growth factor:

You also sell it for $105,000, but you only put down $30,000 to buy the property. Now your profit is $5000 from a $30,000 investment. That’s a 16% return. AND, now you have $70,000 of cash left over to purchase two more $100,000 properties!

But beware; real estate investments can be tricky. In 2008 when real estate values plummeted, many people lost their properties because they were over-leveraged. The loans people owed were too high of a percentage to the value of the properties, and the properties’ value became less than the amounts owed. The same situation can happen in the stock market if you purchase stocks on margin and the value of the stock drops dramatically.

My wife and I have been conservative about the debt to value ratio when we purchased apartment buildings, and it had virtually no impact on us in 2008. The rents were stable, the loans were all paid, and we were able to ride out the downturn. Leveraging good debt takes knowledge, understanding of markets, and reading about and keeping up on trends (see Myth #12). new link to new #12

It takes an investment of time and knowledge to use good debt to build wealth, but it is an investment that can have returns far beyond any paycheck you could earn.

To Your Prosperity,