by Lana Kawaoka | Forbes
Debt is something that is generally regarded as a bad thing. On the surface, it makes sense. Personal finance teachers are very against debt. They offer advice like freezing your credit cards in a block of ice, paying down your mortgage as quickly as possible and never splurging on a $5 latte as ways to avoid or eliminate debt.
But debt is a tool, just like a hammer is a tool. A hammer can do a lot of damage, especially if you hit yourself over the head with one. The same principle applies to debt.
That's why you'll observe smart real estate investors, those people growing legacy wealth, excited about accumulating more debt to acquire properties. There is a difference between "good" debt and "bad" debt.
"Bad" debt is used to purchase things that do not produce more money. "Good" debt makes money by being invested in assets that produce income and capital gains.
I have been asked a lot about whether certain assets or liabilities are good debt or bad debt. There is no rule that a certain interest rate is the split between good debt or bad debt. Although most consumer debt (credit cards, personal loans, etc.) falls into the latter category, it's not particularly because they generally come with interest rates over 20% — but because they create little to no income.
For example, a 4% student loan that allows Junior to get a college degree that doesn't help advance his career would be one instance of bad debt. In contrast, good debt could be a 12% interest rate on a bridge loan to acquire an apartment building that produces 15-25% a year profit. As a bonus, when the funds required for the interest payments plus principal payments come from the investment itself (i.e., the tenant pays the mortgage for you) the loan is essentially free and creates cash flow.
There is a large misconception out there that all debt is bad and there is no difference between good debt and bad debt. The misinformed investor looks only at debt amount and interest rate. But the sophisticated investor looks at cash flow and the impact on net worth. Cash flow is the figurative oxygen that keeps you financially alive, and the impact on net worth is monitored by the percentage of return of equity.
Think of it this way: If you had to wait till you had all the money to purchase a rental property or home in hand, you might never acquire any asset that had the potential to create cash flow above the interest rate payments.
Semi-sophisticated investors may try to not leverage themselves to the max by taking a loan-to-value ratio of less than 80%, considering this to be "safer." However, putting up a larger down payment may drain your cash reserves. The savviest investors know that security lies in the monthly cash flow, which builds up a large cash reserve account. On the flip side, taking out a smaller loan for a smaller asset will yield less cash flow.
Investing without debt is like cooking without gasoline: Of course, gasoline can be dangerous, but if we learn to use it properly, we can see better results. Investors who utilize debt can transcend the current money paradigm that most people live by. Numbers people see it as a simple argument of interest/return rate arbitrage where they pair a lower interest rate with a higher rate of return. It’s a game of arbitrage and it is at the core of the banking industry.
Is Your Debt Good Or Bad?
To evaluate your investments and create an action plan, write all your debts and assets out in a list.
Write down the description, balance amount, interest rate per year and what income it is producing as a percentage per year from the initial cost it took to acquire that asset. Identify which assets are producing the least amount of money after paying off the debt service (interest). Some of these may be negative. Consider selling or liquidating some of those in order to acquire assets that produce positive income.
Real estate is a time-tested asset that produces income and is a commodity where the demand is not going away. However, it's advised to also consider other assets that produce income.
It will take some time but if you prudently leverage your holdings with more and more good debt, you will be able to reap the rewards of a guilt-free, bad-debt splurge such as your dream car, vacation home or private-school education for Junior, because it will be paid off by the cash flow from the other good debt investments. In those situations, you will find a new level of ownership of that purchase because you truly earned it.