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Is debt good or bad?

July 18, 2016

 

debt_imageSomeone recently asked me if “debt was good or bad.”  A better question is, “Which types of debt are good, and which types are bad?”

Consumable debt

This is debt for personal purchases – anything you consume – that is guaranteed to go DOWN in value.  These are vacations, TVs, couches, cars, clothes, boats, etc.

Try this as an experiment.  Take that $70 sweater, or $3000 couch you bought a year ago and look for what it sells for on Craigslist (or try to sell it to learn).  What is it worth?  In my experience, when you add in taxes on a new item, the loss is on average 75%-ish.  Now imagine financing a 75% losing investment.  Financing costs often make make something 50% to 100% more expensive.  Now the loss goes to 90%+.

While you’re paying 50%-100% more than the original price, the value does the opposite – going down 75%.  It’s one of the best ways, most efficient ways to light money on fire.

Zoom out.  Big picture.  People put 5k in their Roth IRA for retirement but have a 40k cars/boats/crap/etc that depreciates at 10-15k/year.  They feel bewilderment about why they never seem to get ahead.  It was mathematically certain when most of the places money is spent decreases in value by 90%.

Here’s the rule.  It’s simple.  Consumer debt = BAD.

If you can’t pay cash for it, you don’t buy it.

The advanced version of that rule is to not only pay cash, but try to buy all of those items for 50-75% off (to avoid the very thing we just talked about).  It’s a skill that once developed makes it almost impossible to pay rack rate for anything.  Multiplied over years, this substantially lowers the bar for monthly personal expenses (making it faster/easier to retire) and funnels more money into savings (again, making it faster/easier to retire).

Investment Debt

This is debt used to purchase things that generate INCOME.

Examples of things that generate income: rental properties, businesses, flipping, etc.

Rental Properties:  This means property that each month pays the mortgage AND makes you positive cashflow.  Keep in mind the higher the debt the higher the risk.  Options here include using a 15 year mortgage or taking your time to buy a property 20-50% below market value.  If bought right, and in an area likely to have quality tenants, this can be a relatively stable investment.  I tend to prefer paying cash for rental properties because I prefer that high level of safety.  But a strong argument can be made for using debt to finance the right kinds of investment properties.  You just need to be sure you can survive down cycles – real life isn’t a clean, linear excel spreadsheet.  No point in having rentals for 7-8 years and then getting busted when the market changes out because you’re overleveraged.  That said, I love rentals.  I know more people who have become millionaires from real estate/rentals who are “normal” people (not inventing facebook) than from any other way.

Businesses:  I have friends who have used debt to buy other people’s businesses and through their management skills to lower costs and raise revenue.  The business then throws off enough cash to pay for the business AND generate a chunk of extra money.  Not only is the value of the business increasing, it’s throwing off extra money, and in 5-7 years it’s paid off and throwing off a lot of money.

Flipping:  I’m a big fan of this approach.  It’s the most basic buy low, sell high approach and it can be applied to almost anything from houses to cars to tons of weird stuff that sells online.  This is the exact opposite of consumer spending, of buying high and eventually selling low.  Instead, you should have already locked in your profit when you buy low.  I like using flipping to generate money as an active full time or part time business and then take the profits and use it to buy passive income producing assets.  Note the debt associated with flipping is usually very short-term in nature (a couple months tops assuming you’re flipping quick, which is the goal).  This is lower risk because it means you don’t have to predict how the market/economy will be doing in 10 years.  You only have to have a sense of how things will be in 2-3 months, which is much easier.

The key thing to note is debt is used here to MAKE money.  With consumer debt, it’s used – often unknowingly – to LOSE money.

And simply put, that’s why consumer debt is bad, and investment debt (used carefully/wisely) is good.  One makes you very poor and a financial prisoner.  The other makes you richer and freer.

Advanced.  Final note, I have very successful friends who finance their cars/toys instead of paying cash.  The difference is WHY they do it.  They could pay cash, but if the bank will give them a loan at 3% on the car they want and they then invest it in their businesses / properties / etc and make 20-50%, making them more money.  Note the reason they took the debt on was to MAKE more money, not because that was the only way they could afford it.

Advanced #2. Investments debt can be highly leveraged.  If you buy a rental house with 5% down and the market goes up 5% you’ve doubled your money (in over simplified terms neglecting selling costs).  Great!  If the market goes down 5%, you lose 100%.  Holy crap! This is why if you’re using leverage that I’m a fan of buying fairly substantially below market value.  That way if the market goes down you have space built in when you bought.  Otherwise the margin for error depends on hoping the market goes up / nothing goes wrong.  In my view, better to be patient and move slow and be safe.

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