Is debt good or bad? It depends on your point of view and how you utilize debt. There are some well-known proponents that say stay out of debt no matter what. Debt is bad. I disagree. Debt is a tool if used wisely. Read on to understand why debt can be good.
In a previous post we discussed leverage. Using debt is using leverage. Using Other People’s Money (the Bank’s) to purchase cash producing assets. Using debt to buy a new car or boat or a bigger house than you need, is not a wise use of debt.
Leveraged debt, especially when utilized with an inflationary period, will magnify your wealth. We will discuss inflation in the next post. Let’s first start with talking about assets versus liabilities.
ASSETS vs LIABILITIES
Most people think of an asset as something that has value. Your car, your house, maybe even some things in your house like appliances or electronics.
This is FALSE. Those items, not even your house, are NOT assets. What are they? They are liabilities. How or why are they a liability? A liability is something that costs you money to have or maintain it. Even if it is something that goes up in value, such as your house. If you lose your job and can’t pay it, you will lose it. If it is totally paid off, it is still a liability because you still have to pay for things like taxes, insurance, and repairs. So a LIABILITY is something that you are responsible for paying for or maintaining.
An ASSET on the other hand is something that makes you money. So, a rental property, a car you lease out to others, a business that is profitable. Now these may not agree with the standard definitions of assets and liabilities but in the FIRE and Real Estate Investor community this is how they are more properly defined.
How can you convert a liability into an asset?
If you have a house you live in, you can rent out rooms, or rent out the whole house on Airbnb when you take vacations, you can rent your car when you aren’t using it on places like turo.com.
Bringing it back to the topic of good vs bad debt. When I was young the difference of good vs bad debt was whether or not it was necessary. A car to get you to work and a house to live in were considered good debt. Maybe even student loan debt to get you a better job.
And to some degree that is still true, as long as you only do it to the extent that it is necessary. You can probably get to and from work easily with a well-used car you buy for $3,000. Sure you can do it also with a new truck that costs $50,000. But that would most definitely be a bad debt. With the only exception if your work has something to do with construction and you are hauling equipment and materials, but then that would likely be a business expense anyway. Depending on your family dynamic, you may be able to live in a modest two or three bedroom home well under your budget and well under what you are “qualified” to buy based on the loan amount the bank is offering you. You don’t need to buy the maximum house you can “afford”. This is the folly most people get themselves into. The bank approved you for $250,000 so that is what you look for. You may find a perfectly good house for $120,000 and be under your budget.
Meeting BASIC needs I believe is acceptable. DO NOT take on so much debt that it affects everything else. If you have too much debt you cannot get qualified for loans from banks. Your credit score may go down which affects what type of loans you can get.
Take this advice; “Don’t buy THINGS, buy ASSETS”. Especially in your early years. Don’t try to keep up with the Jones’. Let them bury themselves in debt. You should avoid things you don’t need and instead purchase wise investments in things like real estate. ASSETS that produce income. That way those assets pay themselves down and have additional income for you.
When is it a good idea to use the maximum loan amount the bank will give you?
If you use it to house-hack. If you don’t know, a House-Hack, is a situation where you rent out part of your home. If it is a 2+ bedroom house maybe you live in one room and rent out the rest to friends. Or even some people rent out all the rooms and sleep on the couch for a year to then move on to another and repeat it. Or buy a small multi-family such as a duplex. This way you can rent out one of the units and live in the other, or even live in the other and still rent out the extra bedrooms on that side of it. This way the property is producing income and likely producing enough to completely pay for itself and maybe even a little extra. That means what you would have spent to pay for housing for yourself, is now going directly into your savings.
If you are able to achieve that, then that is VERY GOOD debt. You are leveraging the bank’s money to buy a cash producing asset. This is the best scenario because not only does it save you the expense of paying for it, but it also improves your ability to buy more. Banks will look at you as a preferred customer and give you the best rates.
You being a person with a mortgage and a car payment, both more than you need, and possibly some student debt or credit card debts, you are a risk to the bank. They won’t want to give you more money because your level of debt-to-income is too high. You don’t make enough income to support the debts you are taking on.
However, if you can reduce your liabilities by converting them to assets, the income they produce are included in your total income and now your income surpasses your debts and you can therefore qualify for more loans so you can buy more assets. Notice I said buy more ASSETS, not go and buy a newer car or motorcycle.
It is a hard thing to control, but once you change your mindset to focus on building assets, over a period of not many years, you will see that eventually you will be able to buy those things that you want completely from the passive income the assets produce.
Your BIG burning WHY
You need to have a WHY, your reason you are willing to make sacrifices to get to that point. Just wanting to be rich isn’t motivating enough. For most people it has something to do with family. Being able to be free to take vacations and spend time with family and to take care of their loved ones. Eventually those assets will produce more income than what you earn from your job. Then you have the option to potentially leave your job if you want, or explore other options for something you enjoy more, even if it pays less. You get the freedom to choose.
So, is it worth giving up all that just to have the nicest or coolest car and the biggest house? For me it is not. Make the sacrifice when you are young, or even if you are not young and just getting started. I didn’t learn these things until I was 40. The sooner you start the better. Invest wisely and don’t take on unnecessary debt. Why not just save and buy those assets in cash? Review my previous post about LEVERAGE to understand why using debt wisely can increase your wealth at a much faster rate and get you a much higher return than purchasing in cash.
Financially Free is better than Debt Free
Remember, DEBT is not bad. It is a tool to get you to financial freedom and to build wealth. Like most things it can be used in a bad way and hurt you. Be wise and use debt to buy cash producing assets and avoid unnecessary debt. The richest people in the world have debt. They understand it and use it to their advantage. Debt when used as a tool helps you to be financially free, the assets they purchase pay for themselves. Financially Free beats Debt Free.