What is 'Good' Debt?

Is it just me or is money just an imaginary thing that we all accept as real? Since we are off the gold standard, this paper is tied to nothing! How does it work? Now with everyone's bank online, it's just a number on my phone!? Maybe that’s something I should look into for a future newsletter.

A few weeks ago, Mike explained some helpful ways to get out of debt. He detailed the main methods to tackle the debt you already have. Today, I am going to take it a step back and talk about what debt to get into in the first place.

Dave Ramsey would argue all debt is bad, and a debt-free life is the only way to live. For some people, a debt free life is a great goal. Personal finance is personal. However, I disagree with Dave and love good debt.

Good debt is any debt attached to an asset with a positive cash flow and/or a reasonable expectation for the value to increase. A lower interest rate will increase your cash flow and return, but there are good deals with high interest rates.

Bad debt is the debt attached to liabilities like cars and credit card debt. These liabilities will not generate cash flow or increase in value.

Let’s define the difference between an asset and liability. I am going to steal Robert Kiyosaki’s simple explanation on this. An asset is anything that puts money into your pocket. A liability is anything that takes money out of your pocket. He goes into depth on this difference in Rich Dad Poor Dad (great book).

Assets: stocks, ETFs, rental properties, and businesses

Liabilities: cars, credit card debt, and primary residence*

Robert argues that the home you live in is a liability because every month it is costing you money and making you none. It is a mindset that encourages living in a home big enough for your family and small enough for your budget. Generally speaking, you should not buy a home beyond your means thinking it will increase in value and be a good investment. Since 1991, home prices have increased 4.3% per year. Right now, a 30-year fixed mortgage rate is above 7%. Meaning, the cost of the loan would exceed the appreciation. This does not take into account repairs or closing costs.

Having said all that, I still think your primary residence is good debt as long as you take the loan with a plan and expectation management. If you move, you can rent out your home to generate additional income. If you enjoy doing home projects, you can increase the value beyond normal appreciation. But, this still begs the question, why would you take a loan if you could buy a house with cash?

Other People’s Money - OPM

OPM is how people use leverage to become exceedingly rich.

Let’s say you buy a $1 million dollar home (the math is easier for me) and sell it five years later for $1.1 million.

If you buy it in cash, you spent $1 million dollars and made $100,000. You earned a 10% ROI (Return on Investment).

If you take a loan with a 20% down payment, you spent $200,000 and made $100,000. You earned a 50% ROI.

Your return on investment was 40% higher by taking a loan. You leveraged OPM to increase your return. You could then take that unused $800,000 and invest it in the stock market. Or you could have bought four more $1 million dollar houses, rented them out, and gotten really crazy!

This is a simplified example to demonstrate the point. For one thing, it doesn’t take into account interest and costs associated with taking the loan. However, the money you could earn on the $800,000 in the stock market would cover the costs and more if given enough time.

Additionally, if you buy the house in cash, that value is not easily accessible. If you wanted the money to buy another asset, you would have to go through the long, expensive process of taking out a mortgage or HELOC. If you put $800,000 into the stock market, you could sell to cover any unexpected expenses or purchase other assets. By buying the house in cash, you lose flexibility.

Dave Ramsey realizes that most people don’t have the ability to buy a house in cash. He advocates for aggressive additional principal payments to pay off the mortgage early. Mike walked through how the value in that plan depends on your interest rate.

Homes are the most common way people are “leveraged.” It is not the only way though. You can leverage other assets like stocks. This is how billionaires take massive loans to buy their yachts, write off the interest payments, and pay next to $0 in taxes. Depending on your feelings on billionaires, that either made you extremely mad, jealous, or both.

Good debt is still stressful. It takes time and effort to manage multiple mortgages and business loans. Additionally, a housing market crash and/or recession can cause serious problems. Good debt allows you to acquire assets to generate additional income but increases your risk and exposure. Like everything in life though, fortune favors the bold and there is no reward without risk.

Call to Action

If you are planning on taking on some good debt, first determine your plan. There are several good options. The only bad option is winging it and hoping it will work out.

What We’re Reading/Listening To:

Podcast: All the Hacks episode #117: Navigating a High Rate Market: Buying a Home, Preparing for a Recession and Where to Put Cash with Ben Carlson.

Debrief on Deck

Next week, Mike is back in your inbox unpacking the complicated question of “how much money do I need to retire?” Apparently, my answer of “butt loads” isn’t technically correct.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (Twitter and Instagram).

Until then, stay the course.

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