How debt can be your best friend
Most of us have been conditioned to fear debt and avoid it at all cost.
So why does debt propel one person to great riches and another to poverty?
Why do the majority of wealthy people manage large amounts of debt?
Can debt then be a positive thing to help us get ahead, or is it always a negative thing to be avoided?
Before we can accurately answer this, we need to clarify our definition of debt. The same one word can be used to describe three very different borrowing strategies.
Let’s look at these three different types of debt and dispel any confusion surrounding this subject.
Horrible debt is debt that will keep people poor. The less horrible debt we take on the better.
Horrible debt is entered into to buy things that depreciate (go down in value) and offer no tax deduction for having made the purchase.
This is exactly the type of debt that we should run and hide from.
Horrible debt, typically credit card or consumer debt, is what the masses enter into every day, usually without a second thought.
Of course, we must spend money to buy clothes, food, petrol, children’s education and so on.
But maybe we should consider a budget, living within our means and delaying the purchase of that flat screen television, or the new lounge suite that we so desperately “need” (i.e. want) until we can pay cash.
Many would consider the family home to be bad debt. We disagree with this view…
As the name implies, tolerable debt is not all bad, but it’s not all good either.
Put simply, tolerable debt (as with horrible debt) does not attract any tax relief, but is used to purchase appreciating assets - i.e. things that go up in value.
Typically, tolerable debt is used to buy the family home.
Most of our industry peers and analysts tend to put all debt into one of two categories – good debt and bad debt.
Many would consider the family home to be bad debt. We disagree with this view, and while acknowledging that the family home is not good debt either, we do believe it’s not fair to put it into the same category as credit card debt for that new big screen television.
Productive debt is the type of debt we want as much of as we can responsibly get our hands on.
Productive debt works for us.
In a nutshell, productive debt is used to invest in assets that appreciate in value and offers tax relief as a result of having made the purchase/investment.
A loan for investment property is productive debt.
By way of example
If you can invest in a $420,000 property that appreciates at 7.2% a year (i.e. 10 years to double) and you are paying only $65 a week to fund the loan (after the taxman and tenant have paid their share), in 10 years, based on this appreciation, your property would be valued at $840,000, and you’ve paid only $33,800 (i.e. $65 x 52 weeks x 10 years) to fund the loan.
That means your debt has made/earned you $386,200, which makes it very productive debt.
By the time your property has doubled in value, it’s likely that your rental income has too; meaning the $65 a week shortfall (even though factored in for this example) is unlikely to still apply.
Taking this into consideration, you can see how one person’s horrible debt can keep them in poverty, while another person’s productive debt can be the catalyst for them to responsibly create wealth.
The MRD way is essentially to avoid horrible debt.
What you may not have understood yet, however, is the incredible wealth, creating power of properly harnessing productive debt.
Property Investing in the Post GFC World
This article was taken from Chapter 4 of my book ‘Property Investing in the Post GFC World’ (but a slightly edited).
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It’s time to take your financial future seriously
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