December 1, 2014

When is Debt a Good Thing?

when is debt a good thing

Debt. It’s a dirty word and there are many negative connotations associated with the word. The fact is, debt can be good, if used wisely.

You’ve probably heard the saying before that money makes the world go round. Well, it’s true. Most first world economies are built on debt, it sure to all come crashing down around us one day, but that’s a topic for another post

Granted, if you are on this site and reading this article, you may not agree that debt can be good.

It may be that debt has been a chain around your neck and caused you untold misery and heartache.

The fact remains: debt can be leveraged to create vast wealth but it must be treated with respect.

I disrespected debt, using it to buy things that I never really needed. Things that would, for a few hours anyway, satisfy that craving I had to amass status symbols and useless gadgets.

This sort of debt is rarely a good thing. it does not produce any real value, it only acts as a drain on your financial resources.

Good Debt vs Bad Debt

It's almost impossible to live debt-free; most of us can't pay cash for our homes or for our cars and unless you're Bill Gates or Sir Richard Branson, the chances are in some point in your life you will need to borrow money.

It is a circumstance that will arise in everyone’s life at one point or another.

Most people borrow this money for their own personal consumption, but some of the more astute among us borrow money with the sole intention of making more money.

The trick is spotting an opportunity and that, is no easy task.

These people leverage debt in such a way that the cost of borrowing is outweighed by the return that they will get on their investment.

Below, I have outlined a few of the different ways in this is possible.

Mr Small Business Owner

Mr Small Business Owner is the master of leveraging debt in order to create wealth. While it is possible to start a business with just a bit of pocket change, most small businesses will need capital to get off the ground.

Money to buy goods to sell and / or pay the typical overheads associated with a business, rent, rates, staff etc are needed to see a business through its first few lean months before the clients and the money starts rolling in.

Mr Small Business Owner will often go to the bank for this money. They will make him walk over hot coals to get it, but once he (or she) has it they can put that capital to work to make a return on their investment.

The hope is, that the net profit (revenue minus cost of sales) is enough to cover the cost of the loan.

If it is, voila!

Mr Small Business Owner has turned his debt into a cash producing machine.

Debt, when used in this way means businesses can scale their operations to take on more staff, buy more stock or take on more stores even if they don’t have the funds themselves.

The businesses that really succeed are the ones who continue to recycle their profits back into the things that produce the best return on investment.

This concept works on the smallest possible scale.

You could go out tomorrow and buy some car cleaning gear on your credit card. It may cost you $100 to buy enough car cleaning supplies for a year.

In addition, you may be paying 18% interest per annum on your credit card purchase, but once you had your bucket, soap and sponge you could clean cars until your heart was content.

Your opportunity would only be limited by your desire to graft and hussle.

$100 borrowed at 18% and repaid over one year - $9.17 a month.

That’s it, you would need to make more than $9.71 a month to make that debt work for you.

That’s like, 1 car!

Home Owner

Now, this may be controversial to some. Especially those who got hammered by the GFC and saw equity in their own homes drop but, long term, home ownership is going to make you wealthy.

As Mark Twain says

“Buy Land, they are not making it any more”.

Mortgage debt is often the cheapest form of debt. It is secured against your home, which acts as the collateral against you running off into the sunset with a huge wad of cash. Therefore banks usually see it as a fairly safe bet.

How can you leverage mortgage finance to make you wealthy.

Well, not everyone can. Accessing the property ladder usually requires a pretty heft sum of cash to start with but, as the explosion of home improvement shows, proves, making money through home ownership is a very popular past time.

Take this admittedly very basic example:

A lady, lets call her Jill, buys a house in need of some work for $140,000

She stumps up a 10% ($14,000) deposit from savings.

She spends $20,000 on improvements (new kitchen, bathroom, carpets and a paint job).

Sells house for $175,000 (minus agents commission and 6 months interest + early repayment charge on mortgage loan)

Profit - $15,000

Granted she had to find the $34,000 for the deposit and the improvement works which, clearly, not everyone is going to have access to but the best part about this, she has risked the banks’ capital to create more wealth.

Now, you can still get in trouble with good debt. Mr Small Business Owners business could have no clients, and Jill may have timed the market wrong and failed to sell her renovated house but the point remains that it IS possible to have good debt.

While you may not be at the stage where you are able to put that to use. In fact, if you still have any form of bad debt, the credit cards, store cards, high APR personal loans etc, then of course these need to be paid off.

Just remember though, when treated right, debt can enrich your life as well. Its always worth bearing in mind, you never know what opportunity awaits around the corner.

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