Good Debt vs Bad Debt

chain banner

Debt Is Like Fire

Most people are brought up to believe that debt is bad and should be avoided at all costs, and never touch the stuff for fear that it will consume them.

Others have the belief that if they want to buy something, they simply buy it right now on credit, don’t seem to care or are ignorant of the fact they have to pay a ton of interest on this debt.

These are opposite viewpoints but they have one thing in common – they’re both dead wrong.

Using credit to fund expenses and things you don’t need is a terrible idea! You’re going to get burned by uncontrolled interest payments because you have to pay the lender extra money each month for the right to use their money, and you have to fund this somehow from your earned income. This is great for the lender, but not for you.

But those who refuse to go near debt are missing out on a huge opportunity – to buy high yielding investments using other people’s money! This is the easiest and surest way to get rich. By using your own money, you could be saving a lifetime to afford a rental property investment, but by borrowing that money from the bank you can jump on the bandwagon far sooner. People who refuse to touch debt are playing it safe – they will not get into credit trouble, but nor will they get rich.

There are two sides to every coin, and there are two sides to debt. Debt is “good debt” when it is used to buy an asset or investment that pays you an income. This income must be greater than the cost of the interest payments on the debt, thereby negating the cost of the borrowings and leaving you with a profit. Sounds good to us.

Debt is “bad debt” when it is used to buy stuff that will depreciate in value like cars or holidays, and the interest payments are not covered by a newly created income stream. This is the picture of debt as portrayed in the media, the bogeyman-under-the-bed version of debt that should be rightly avoided.

Debt is like fire: used correctly it is a great tool. Use it stupidly and you’ll get your fingers burned.

Debt (also known as leverage) is a key part of property investing

The Property Factor

An example of good debt might be the use of an interest-only mortgage on a Buy To Let property. The mortgage might cost 4% but the returns could be 10%.

Here it was worth taking out the debt, because with the 10% returns on the investment, we’re easily able to pay the bank their 4% cut, and keep the 6% for ourselves. Most would see the logic that this is a good thing.

An example of bad debt is remortgaging your house to buy a bigger car – you’re increasing your monthly outgoings with more debt and higher interest payments in order to buy a fancy toy. Your monthly costs are now more each month than they used to be, rather than you making a profit. You can see why moving your finances in this direction will not make you rich.

In short, good debt is spent on assets that make you money – bad debt on liabilities that cost you money.

One thing we hear too often is people foolishly celebrating paying off their residential mortgage. In our opinion this is an enormous waste of an opportunity. The capital being using to pay off the mortgage could be used to invest in assets that generate additional income.

Let us explain.

A mortgage once paid off means no further debt payments (yay!)… but also no investment income (not so yay).

Alternatively, you may have a £200k outstanding mortgage costing you interest of 3% a year. That £200k could have been invested over the same number of years it would take to pay off your mortgage in assets yielding a 10% return. The 7% difference between the investment return and the interest cost in this example would be a £14k profit each year. Put another way, being mortgage free is costing you £14k per year!

People are actually celebrating missing out on the opportunity to get a large income for life without having to work for it – this is mad!

Most people we speak to are not investing and so for them, avoiding debt would be the safe option. However, everybody should be investing and with a little education you should consider the use of using debt to buy income generating investments as key to your financial plan.

Recommended Posts