Part three in the ‘Fix Your Money Problems Forever' series.
Debt is like electricity. You understand and respect electricity because you know it'll kill you if you don't. Debt can do the same – it just takes a little longer.
But debt, like electricity, can do great things. It can multiply capital, compress time and accelerate outcomes. In other words, it can build you an asset base with less of your own money and get you to self-sufficiency (freedom) sooner. That's why it's often called leverage. As Archimedes, the ancient Greek mathematician said, “Give me a lever long enough and a fulcrum strong enough and single-handedly, I will move the Earth.”
Debt can mean the difference between an extraordinary life – attained sooner – versus a life of struggle and scarcity. Your parents probably grew up believing that all debt was bad (‘never a borrower nor a lender be') and that carrying debt was born out of necessity, not an intentional strategy. My parents could have built a substantial property portfolio (they owned their home outright from day one plus my father was a builder) but as well-positioned as they were, the fear of debt held them back. As such, they never owned a single investment property.
Fear holds people back and the greatest driver of fear is ignorance. It creates imagined fear, which is the worst kind of fear because you'll end up going nuts for nothing. Whenever fear directs you, observe it and ask how much of it is coming from ignorance. If it is, get educated. Not from friends of the family or someone's mate who just did XYZ. No, get your education from those who've consistently succeeded doing what you'd like to learn.
I can't stress this enough. So many people abdicate responsibility for their future to ‘advisors' who don't have the runs on the board. If I want to learn a thing, I ALWAYS ask the teacher or advisor what successes they've had doing that thing. If they can prove it, I'll listen to them. If they're prepared to help and advise me, I act on their advice. If someone asks my advice then does the opposite, I'm inclined to deflect them next time around.
Good, Bad and Ugly Debt
So what's good and what's bad? I've bored you long enough so I'll get right to it. Debt that's used to acquire an accumulating, income-producing asset that appeals to banks and where value can be added is usually good. Debt on everything else is usually bad.
Too simple? OK, I'll give you some examples.
An 80% loan on an appropriate-for-the-area residential real estate asset in a suburb with a demonstrable history of capital growth and wages growth is good debt. An example would be a $560k loan on a $700k free-standing home with enhancement potential in a middle ring suburb. Incidentally, lines of credit used for property acquisition fall into the same debt category.
Bear in mind, though, less than 10% of properties are investment-grade, so this type of debt comes with a few provisos that we don't have time to cover now.
That said, no other investment give you the enormous advantages that quality real estate does.
- You can control a $1,000,000 purchase with just $200k of your own money – even less at higher LVRs (loan-to-value-ratios); though I advocate a conservative, sleep-at-night approach.
- You can improve its value with simple things like paint, plants, a carport, fixtures, window furnishings, a light renovation, etc.
- The government will help you pay for it (depending on where you live) through tax concessions.
- A tenant will help you pay for it (via rent).
- You don't need to sell the underlying asset to realise its gains.
- You can use its growth in value (equity) to acquire and accumulate more property without selling.
- A carefully selected real estate investment is far less volatile than most other investment-grade asset classes because it's mostly driven by fundamentals.
There is a mountain of information on the subject of real estate investing – it's a huge industry. A lot of it is bullshit, too. The principles of real estate INVESTING (not speculation) are fundamentally simple. Yes, there are things you need to know when it comes to suburb/area/property selection, finance, taxation and so on, but it isn't nearly as complicated or scary as some will have you believe. Likewise, it doesn't happen as quickly or magically as many others say. Like all things worthwhile, it requires a bit of time and education to make wise decisions and to recognise a good deal when you see it.
I'll cover property investment in more detail in a future post. Just understand for now that, in my view, good debt occupies a narrow subsection of this particular asset class.
As I mentioned earlier, bad debt – for the average person at least – is just about everything else. One of the few exceptions, believe it or not, is a credit card with 55 or more interest-free days. If you lack the discipline to pay it all off at the end of the interest-free period then no, this instrument is your enemy; stay away from it.
But if you have the wisdom to know the effects of compounded stupid-high interest rates, the maturity to act on that wisdom and the discipline to snub ‘new shiny' syndrome, the credit card is a great tool for two reasons:
- You can deposit all your income into a mortgage offset account, pay all your bills with your credit card and only withdraw what you need from your offset account each month to pay off your card. This systematically reduces the amount upon which your mortgage interest is calculated – saving you interest costs. It's free money.
- You'll accumulate points on your credit card (assuming you were smart enough to get one with a rewards programme), which you can exchange for cash back on your card balance. More free money. You might be tempted to save your points for a new shaver or vacuum cleaner or iPad but don't do it. If you need to ‘buy' something, get the cash back then buy the thing on eBay or Amazon for a lot less than what your card provider charges to exchange points for products. Trust me on this – you'll be far better off. Always exchange your points for cash back then buy your item from the cheapest source, using your card again. More points!
Bad debt includes any instrument (personal loan, credit card, hire purchase, lease, line of credit) used to acquire any depreciating asset. The biggest offender is the recurring car buyer. Spending $36,650 (including interest and fees) on a $30,000 car that you could buy three years old for $15,000 and justifying it as a tax perk is stupid in the extreme. Even if you pay cash for a car – and you should – you can still depreciate that car and claim all the same running expenses just as you would if you stumped up double the price on a new one with a debt noose around your neck. The number of people who justify their vehicle updates with this dribble is laughable. Many years ago I was one of them.
The most efficient way to acquire a car is to buy a ‘last-in-the-series' (all bugs and design issues usually resolved by then) pre-owned car of at least four years vintage (had most of its depreciation hit), with a complete service history and if possible, one owner. Pay cash for it and keep it till it costs too much to maintain, you've had it for ten years or it dies gracefully – whichever comes first. If you can keep it for longer, even better. I haven't had a car loan in years and it feels great. We own two cars that cost their first owners a combined total of just over $300,000. We paid $73,000 for both of them – one seven years ago and the other a year ago. The first one is now 14 years old and still looks and drives like new. The second one is eight years old and it too is just like new. I expect we'll have both of them for at least another seven years – probably much longer.
Debt used to acquire lifestyle products and services is also a terrible waste of money. Boats, PWCs, motorbikes, holidays, any technology product and holiday houses are all terrible applications for debt financing. Why? Well, the first five, like the car, depreciate (the holiday does this instantly). They also produce no income; you can't enhance their value and you have to sell the liability (that's what they are) to recover any remaining equity once your loan is clear.
Debt on a holiday house is more complex than the other items. For one, banks hate to lend against a property that has seasonal or holiday occupation and their LVR (loan to value ratio) and interest rates will reflect this. Also, the servicing and maintenance costs can be very high – eating into returns, and seasonal vacancies can be a real problem from a cash flow and security standpoint. If you want a holiday house, rent one instead. We stay in luxury multi-million dollar houses during the low season and pay peanuts for the privilege. What's more, we stay in a different one every time. It beats the headaches and burden of buying one; that's for sure.
The last kind of debt you should avoid is any store card or card you receive with an interest-free loan facility. These invariably carry obscene interest rates and those with an extended interest-free period (or worse, payment-free period) can lull you into a false sense of prosperity. Once the honeymoon is over you can find yourself with a significant debt for something that was new and shiny a long time ago but now, just another entry on your list of burdens.
Learn to Leverage Debt to your Advantage
Debt can be what Archimedes said – a powerful lever that will lift you higher and further than you could ever go without it. It can also be your undoing. Treat it like electricity, learn how to use it properly and you'll achieve amazing things.
Here are three books I'd recommend for expanding your knowledge of good debt and its application in real estate. Please note these are affiliate links.
I've met Michael personally, studied his book and sought his advice on specific matters. He's a conservative investor, a respected industry commentator and most importantly, a person who's successfully walked the talk for a few decades now. He's the real deal. Learn more about Michael's advisory firm, Metropole, here.
A New Zealand native, Dolf has been investing in different countries ever since he left university. His language is simple, approachable and logical and his advice is easy to action. Don't be put off by the funny name. Dolf's advice is sound. Learn more about Dolf here.
Like him or not, Robert has done a lot when it comes to distilling financial concepts and putting their constituent parts where they belong.
This post is part three of a series called ‘Fix Your Money Problems Forever'. Check out the others in this series.
1. Know WHY you’re Spending
2. Don’t do a Budget
3.Good Debt, Bad Debt and Ugly Debt
4. Trapped by debt? Go on a killing spree!
5. Pleasure-seeking may cost you your freedom.
6. Eliminate Crap from your Life
7. To Save Money, buy Premium
8. Create a Business From What you Know
9. Invest Well and Sleep at Night!
Thanks for stopping by and I hope we get to hang out more in the future. And in the meantime, please feel free to share your own experiences. You can also email me directly at firstname.lastname@example.org. I respond to all emails.
Disclaimer: I'm not a psychologist and I'm not a financial advisor's elbow. This material doesn't constitute financial advice but it is a collection of my personal opinions, based on my own experiences.
Also published on Medium.