Is there such a thing as good or bad debt? In the late 80's, some of Australia's most heavily geared high flyers came crashing down as asset values dropped and banks called in their loans. Greed, a belief that values would increase indefinitely and lack of judgement all contributed to their downfall.
But without debt, few people would be able to generate significant wealth in their lifetime. The old save up, pay it off and start again idea just will not bring home the bacon in time. Our lives simply aren't long enough to allow us to accumulate enough assets in a lifetime using this strategy.
This suggests that debt is not necessarily bad, and in fact it is an essential tool to help us build wealth.
However, there are two different types of debt. The first is
consumer debt, which is used to purchase items which do not generate an income and which generally depreciate in value over time. This includes credit card debt used for personal purchases, car loans, loans for boats, furniture, a holiday, eating out and other items to improve our lifestyle. It also includes all of those buy now, pay later deals and low instalment purchase plans which often contribute to the increasing level of personal bankruptcies in Australia.
The second type of debt is what I call
investment debt. In other words, this is debt which we incur in order to purchase income producing assets such as real estate or shares. Our purpose in taking on this debt is that we believe we can earn a higher rate of return from our assets than it will cost us to service the loan. We may also expect to be able to sell the assets in the future for a good deal more than we originally paid for them so that we enjoy a capital gain.
Provided it is used wisely, investment debt provides the only real way for the average investor to build a substantial asset base during a single lifetime. It means using other people's money to leverage yourself into greater investment returns. It is used in business and has been used by millionaires for a long time.
I say: "provided it is used wisely," because the borrower needs to be able to withstand a jump in interest rates, a dramatic fall in asset prices, a recession, retrenchment, divorce, illness or other financial crisis. Just because a lender has approved a loan doesn't mean that you are isolated from risk. You need to take care not to overextend yourself so that you can service your loans in good times as well as tough times.
A prudent investor will always maintain a "sleep well at night" buffer, either in direct savings or an unused credit facility or redraw facility that can be called upon to even out cash flow crises.
While you may consider your home to be an asset because it may increase in value in the future, it is not usually income producing (unless you take in boarders). Consequently, I classify your home, car, sound system, furniture and so on as liabilities, because they cost you money.
Here are the Top 10 Points in managing debt successfully:
- Prepare a budget before you borrow
- Do your sums. Can you service the debt comfortably?
- Consider a worst case scenario. How will a possible job loss, injury or illness affect your ability to repay your debts? Do you have any Savings to allow for unexpected events?
- What is your contingency plan if things don't go as planned? Understand your tolerance to debt. Can you handle it or will you make yourself sick with worry?
- Decide to invest based on investment fundamentals. Steer away from tax driven strategies or unbelievable rates of returns. They often result in large losses.
- Do your research and look for genuine opportunities. Don't follow the herd. Look to buy low and sell high.
- If it seems too good to be true, - it probably is! Check it carefully before you jump. Make sure you seek independent advice from someone who knows what they are talking about. Ask Questions!!
- Keep track of your finances and investments - review your position every 3 - 6 months.
- If you find yourself in trouble take corrective action immediately - face up to your situation and deal with it. It's better to stay in touch with your creditors and keep them informed of your position than to bury your head in the sand. You'll find that you have a better chance of overcoming your challenges if you let everyone concerned know what's happening.
- Stay on top of your bills and make sure that if you are stretched, everybody gets paid something so that they will continue to support you.
About Hans Jakobi
Hans Jakobi is an educator, author and investor. He is the author of six best-selling books including, How To Be Rich & Happy On Your Income which is available at:
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