“Debt is bad! Crush your Debt! Get Debt Free!”
If you read as many personal finance sites as I do, then you’ve seen at least one of these messages within the last week. Debt is definitely on the minds of a lot of people.
And with good reason. The average American holds $5,700 in credit card debt. Still, it pales in comparison to $1.48 trillion of student loan debt. That’s about $620 billion more than all credit card debt. Add in car loans, personal loans, mortgages, and business loans and it’s easy to see that there is a lot of money tied up in debt.
Debt can cause stress and anxiety about your finances and can be the biggest thing holding you back from wealth … right?
I’ve had many friends ask me about debt. How to get rid of it, how much is too much, what to do with my federal student loans, and should I take on more debt; are all common questions I hear.
For most people, the advice is simple. So simple it takes just 4 words: pay off your debt!
If debt is a concern for you, pay it off. Spend less than you make, and apply the difference to your debt. When all the debt is gone, you put that money towards investing. It’s simple, basic, and works. I won’t be mad if you leave right now and just go do that. My job will have been done.
But, for those in the latter stages of their wealth journey, we know it’s not that simple.
The truth is, debt is not evil. Just like money isn’t evil, it’s just a tool, the same goes for debt. I personally, along with many others, have been able to use debt intelligently to increase my net worth. If you are serious about building wealth, it’s important to master debt on an advanced level.
What is Debt?
Debt is you owing someone else money.
Really. That’s all it is. It doesn’t matter if it’s Sallie Mae, a payday loan provider, a car dealership, or your cousin … it’s all debt.
When it comes to all types of debt, there are too many to count and they are making up new types each day. There are all types of ways to structure it, break it up, repackage it, resell it, and different terms and conditions many of us will never have to deal with or encounter.
But, when we hear “debt”, it’s typically consumer debt (not business debt) we are talking about and is what we will focus on here. Some well-known forms of consumer debt are:
- Credit Card Debt
- Payday Loans
- Car Loans
- Personal Loans
- Stock Margin Accounts
- Business Loans
All debt has a few important components:
- Interest Rate: The cost of the interest on the loan expressed as a percentage.
- Term: How long until you have to repay all of the debt.
- Payment Terms: Monthly, yearly, and balloon payments are examples of different types of payment terms.
Depending on what type of debt, there can be a lot of additional rules, conditions, and other important factors. But, these 3 components can help you separate good debt from bad debt and understand the cost of holding debt.
What’s the difference between Good Debt and Bad Debt?
I’m going to keep this super simple:
Good debt is used to make more money than the cost of the debt. All other debt is bad debt!
Good debt creates wealth. Bad debt destroys it.
Bad debt has high-interest rates and is used for spending and personal purchases. Credit cards are the worst, but high-interest car loans, personal loans, and payday loans are close behind. Bad debt is debt spent on things you don’t need. To make it worst, you end up paying more because of the interest you pay on the debt.
Good debt is used to acquire wealth generating assets and the cost of the debt is smaller than the return of the asset. A mortgage for an investment rental property meets these criteria. The cost of the mortgage is less than the extra income we’ll bring in and we are using it for something to increase our net worth.
I’m going to take it a step further and define “OK Debt”. Yes, there is a type of debt that isn’t good or bad, but it’s just OK.
What is OK Debt?
OK debt is any low-interest debt used to buy a necessary purchase. The interest rate of the debt must be lower than your average investment return.
You may not have heard of OK debt before … because I made it up. But, it’s an important concept in order to master debt. It’s important to realize that OK debt only comes into play once you have the fundamentals of personal finances down. Including knowing your net worth and diligent investing.
In order to have OK debt, you must be investing your money and that money must be earning a return. For example, a basic diversified portfolio of stocks and bonds is a good example. You can always put more money in and it will generally earn a consistent long-term return. Everyone’s return is different, but I aim for 8% yearly growth of my assets. This is based on what I’ve been able to earn in the past.
So, if I know I can earn 8% on anything I invest, any debt with an interest rate below this rate of return should be held. This is because I expect to make more money investing compared to the money I save paying off debt. Instead of putting cash towards this debt, in theory, I am better off investing this money.
An example of OK debt is a low-interest rate used car loan, let’s say a 3% interest rate loan. If you need a car and have the cash to purchase it, you have a decision to make. You could pay cash, or take out a loan and immediately invest the cash instead. The invested money would earn you more, an estimated 8%, compared to the 3% you pay on interest. In this case, it makes more sense to take out a loan instead of paying cash.
It’s very easy to claim that buying a new house or new car is “OK” debt and won’t hinder your wealth. But, that would be lying to yourself. If you spend money you don’t have on things you don’t need, you are creating bad debt. Understand the difference between leveraging debt for wealth creation and just creating more debt. Don’t attempt to think in terms of OK debt if you aren’t consistently investing your money. If you don’t get the returns you expect, the math breaks down and you will lose money by not paying off OK debt.
OK, So How Do You Approach Debt?
Mercilessly kill bad debt.
I mean really imagine that bad debt slapped your mom, spit in your grandmother’s face, and burned your childhood home to the ground. Get rid of any bad debt that is around you, sucking the life out of your wealth. Hunt it down and eradicate it using the debt avalanche or debt snowball method, allocating any spare money to paying off debt.
Look for debt with high-interest rates, anything above 10% is a red flag, and that isn’t associated with a money generating asset. Credit cards, payday, and personal loans are all great places to start.
Intelligently Eliminate OK Debt
You might have an old student loan payment at a super low rate, or a car loan at low-interest rates, or a mortgage for your personal home with a low APR. When it comes to allocating money between paying off debt and investing more, make intelligent decisions that align with your personal goals and consult a professional.
You should always monitor your personal debt to assets ratio. This tells you how much debt you are carrying compared to how much you own in assets. If you are highly leveraged, there is a lot of debt against your assets and you may be taking on too much risk. If there is a major correction or drop in the value of your assets, you may owe more than you own and destroy your net worth. This is how so many “rich” people end up filing for bankruptcy.
Personally, I pay off OK debt from time to time. For example, as the stock market rose recently, I took some of my gains and put it towards OK debt, taking my gains out of the market. If I want to move money out of the stock market, OK debt is a great place to put it. Paying off a loan with 4% interest is the same as earning a 4% guaranteed return, better than many bonds. This has led me to significantly pay down my OK debt over the years.
Seek Opportunities to deploy Good Debt
If you didn’t know, I like real estate investing. It’s an asset class that is proven, well understood, and has provided me with solid returns. It’s also an asset class that lends itself well to using good debt.
When I purchase a rental property, I get a mortgage on the property. I do my research to ensure the rent will cover my mortgage and all my expenses, but I want to avoid having to pay for a property in cash. I am using debt that is cheaper than my expected return, aka “good debt”.
Rarely, I will tap into my margin account to make stock investments. If I see an opportunity for a good long-term purchase but don’t have all the cash for the position, I will tap into my margin account and pay it back over time from my regular monthly savings.
I use Personal Capital to track my net worth, my debt, and my assets in one place. It’s free and I’m a big fan of their net worth tracking features. It’s especially useful in tracking my debt-to-asset ratio. I want to ensure I’m not over-leveraged, exposing myself to a lot of risk in a downturn.
Be careful in aggressively acquiring new debt. Even if it’s good, it’s still debt and increases your debt-to-asset ratio, which increases risk.
Remember, Debt isn’t all Bad, But Most of It Is
When it comes to truly making wealth, debt is a necessary tool. Most of it is bad and should be destroyed. But, if you refuse to use any debt you will miss out on a lot of wealth creation opportunities.
Do you have your own story about utilizing debt? Are there other tactics you’ve seen used? Leave a comment and share with the community.