Our parents say not to get into debt, but is that true? Most people have debt as part of their lifestyle, and most are even in debt for most of their life. Some say there is good debt vs bad debt; is this true?
Not all debts are created equal. Debt is like a double-edged sword. If managed effectively, it can be a powerful wealth-building tool. However, irresponsible use of debt can trap you in a never-ending financial difficulty cycle.
What is good debt?
In short, good debt makes you wealthier.
Debt is usually good when being used to acquire good quality assets. Because assets generally appreciate over time, it is a relatively safe way to use debt.
Buying assets with debt may reduce the need for initial capital and increase the return on capital to acquire those assets. In other words, if you use less of your own money to acquire one asset, it will take you less time to accumulate enough initial capital to acquire another asset.
Good debt should also have a relatively low-interest rate that you can comfortably afford. The servicing cost of the debt should be lower than the return on investment from your assets.
Example of good debt
Mortgage
Most of us cannot afford to buy a property in cash without a mortgage. Thus, using a mortgage opens up the opportunity to own a property. If you can secure a mortgage with an affordable interest rate, and your property is expected to appreciate (or generate rental income) more than your mortgage interest, then you have found a good case for taking the mortgage.
Business loan
Business loans can be a powerful tool to grow your business. Most businesses take some debt to fund their growth and operation. Even the most profitable companies in the world use debt to their advantage. If the interest payment is low enough such that they can service the debt comfortably, this is another good case for taking the debt. It can help speed up the growth and expansion of the company.
Student loan
Getting a loan to further your study is usually a good proposition. A degree from a good school may help you increase your income potential for the rest of your career. Student loans usually enjoy a relatively low-interest rate as well as tax deductions.
What is bad debt?
On the flip side, bad debt makes you poorer.
If you are using debt to buy consumables or liabilities, this is the recipe for bad debts. Liabilities will depreciate over time. Thus, the depreciation and the interest from the debt will take away a lot of money from your pocket.
High-interest rate is also another recipe for bad debt. If you use debt with a high-interest rate, even if you are buying an asset, it will still be difficult for the asset appreciation to outperform the cost of servicing the debt.
Example of bad debt
Credit card debt
Credit card debt is an example where the interest rate is unreasonably high. You want to avoid this debt at all costs. With such a high-interest rate, even if you use it to acquire an asset, it is still hard for the appreciation to outperform the cost. If you use it to buy liabilities, the effect is even worse. Pay your credit card bills on time to avoid such a high-interest rate.
Car loan
Car is usually a liability, thus taking a loan to buy a car is the characteristic of a bad debt. The car itself will lose value over time, and the interest rate for the loan also adds to the total loss in value.
You need to understand the difference between good vs. bad debt so that you can get rid of the bad debts while using the good debts to grow your wealth.
Should I get in debt and when?
Remember, a well-managed debt can be a powerful wealth-building tool. If you want to grow your wealth faster and have the risk appetite for it, getting into debt may be a good proposition for your case. Keep in mind that you generally want to get into debt:
When you use the debt to acquire assets and not liabilities
Only acquire good quality assets that are not volatile and expected to appreciate over time.
When the debt has a relatively low-interest rate
We also recommend that the interest on your debt is lower than the appreciation of the assets you acquire.
When you can afford the debt and within your risk tolerance (don’t over-leverage)
- Always ensure you have the means to service the debt, ex: a stable job with a monthly salary.
- If the debt requires collateral, take note of the valuation of this collateral. This collateral must not be volatile in value. If the valuation of the collateral drops, your lender may require you to add more collateral to offset the drop, or they may seize your existing collateral to reduce their risk. Avoid forced liquidation when your collateral value is down because this may cause a massive loss. Do not over-leverage, and always add a margin of safety.
Bonus: How do the rich use debts?
Do the rich use debts differently than us? Well, they mostly do the same thing. The difference is that they use debt more strategically and generally have more access to debt than average people.
- Just like everyone else, the rich use debt to acquire assets. With less initial capital, it allows them to grow their wealth at a much faster pace. Many wealthy people are in debt and purposely maximize these good debts to acquire as many assets as possible.
- When they need liquidity, instead of selling their assets, they strategically use debt to get the cash by pledging their assets as collateral. This method allows them to enjoy the appreciation of the assets while having liquidity. Note: This is a dangerous game if you do not know what you are doing, and reserved only for sophisticated investors.
- The rich are also on both sides: the lender and the borrower. Yes, that is right, they borrow as well as lend. They make the world go round.
