Good Debt and Bad Debt
Good debt. Most people are afraid of debt. Most people have experienced debt or currently have some kind of debt.
Yet most rich people have tons of debt.
There are two kinds of debt: Good Debt and Bad Debt.
When regular people think of debt they are usually thinking of bad debt.
Bad debt is the kind of debt you get by purchasing consumer goods that depreciate and that don’t provide any kind of financial return. For example, your car, your trips, furniture, clothes, etc.
I’m not saying don’t enjoy those things … just don’t go into debt to buy them. Don’t put these things on your credit card and carry balances from month to month.
Don’t take out loans to buy a new car.
I know people think that’s crazy … what do you mean I can’t buy a new car … I can’t afford a new car without taking out a loan. Then you can’t afford a new car if you have to take out a loan. You should be putting money aside every month every year to save up to be able to buy a car without a loan. Those are expensive loans.
And you should only be buying these things only after you have your savings and investment program well under control.
Usually, this debt starts as credit card debt or consumer debt. And this debt has a very high-interest rate. Most credit cards charge 18%, 19%, 20% and can take a long time to pay off. So, not only are you incurring that debt but you are carrying it over many years because most people only pay the minimum balance.
You should never borrow for consumer products.
Save first and then purchase what you want or need. And even then … make sure you really need these items.
Good debt, on the other hand, is debt that is used to acquire an investment.
An investment is something that you buy that’s going to provide a return that’s going to offset any kind of debt payment that you have.
For example, you can borrow money from a bank to purchase a rental property, or from investors to acquire a Lease Option, or even take out a loan to invest in higher-return mortgages.
There are all kinds of ways to make money outside of your normal RRSP or mutual fund type of investments.
As long as you are getting a positive cash flow then it is good debt (no, your boat or jewelry is not considered an investment). And if your investment also appreciates, that is a bonus.
Your personal residence is not good debt.
People think, oh I have to live somewhere. If you aren’t structuring your home purchase properly, then you are actually losing money by putting money into your home and not using that money to get a return. I have helped people actually figure out how to use their home to accumulate wealth and at the same time pay for their mortgage on a regular basis.
It amazes me that people are afraid to take on this debt because they are afraid that they might get stuck with the monthly payments.
For example, if you own a rental property and the rental unit is empty, how do you make their monthly mortgage, insurance, and tax payments?
Proper planning and vacancy reserves will fix that.
What that means is if you ever have a vacancy you’ve got some money set aside to offset your lost rents. I recommend always having six months of reserves in place to handle such things as vacancies or any kind of unexpected maintenance
For example, if your property is renting out at $1,000 a month you should have $6,000 in the bank in your investment account to be able to weather the storm for any of those problems.
Yet somehow these same people are OK purchasing a new stereo on credit and making the monthly payments because they don’t have the money to pay off the balance every month.
Because people have had so many bad experiences with bad debt, they are very hesitant to take on any good debt.
I see this every day with people who own their own home and have their home completely paid off. They are proud of the fact that they are mortgage-free. They are sitting on this big pool of dead equity that isn’t earning them anything except for the appreciation, and that only helps them if they sell.
They think it’s the greatest thing they’ve ever done. They bought their house for $80,000 35 years ago and now it’s worth $300,000. “Did I ever do good on that investment”. Well no …. not if you don’t sell it. And where will you live if you do sell?
If they were to take out a mortgage on their home for let’s say 3% (roughly today’s rate) and invest it in high ratio mortgages or any other investments at say 13% (the average returns that I guarantee my investors) they would make an easy 10% profit.
If your home is worth $300K and you took out an 80% loan to value mortgage, you would have $240K to invest. At 10%, that would be approximately $24K extra income per year. Not bad for just refinancing your home.
I don’t know about you but most people would like to see an extra $2,000 coming in every month. People look at it as it’s a risk. But if it’s done properly you can reduce that risk.
So you really need to look at good debt as a way of making investment opportunities available to you so that you can earn extra money on a regular basis.
Rich people aren’t rich because they make more money. Rich people are rich because they know how to manage their money. And they know how to manage their good debt.
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