Tuesday, August 17, 2010

Know Your Debt!


Money can buy almost anything (except love). You can even purchase money with money. The cost of money is determined by interest rates when it is loaned out. Interest is a certain percentage of the total loan amount (the principal) that is paid over a period of time, until both the principal and all the accrued interest is paid off. The longer you hold the loan the more interest you pay. For instance if you were to borrow $1000 (the principal) from the bank at an annual interest rate of 5%, than at the end of the year you will owe $1050. In this case the cost of borrowing for over a year was $50.

All of us, at one point or another will take on some sort of debt. There are many forms of debt, for example: a mortgage on a home, financing on a vehicle, or credit card debt (consumer debt). With all these different forms it is important to be able to distinguish between what a good form of debt is and a bad form of debt.

We are raised on the belief that all debt is bad. That having to pay any interest at all is a bad thing. The truth is there are good forms and bad forms of debt. Being able to distinguish between the two is a critical component of building our financial intelligence. When we can distinguish between the two, we can attempt to eliminate all of our bad debt in our life and take on as much good debt as we can safely handle. Let’s take a look at some of the differences.

Good Debt
1) Mortgage on a Rental Property – this is a beautiful example of good debt. After making a down payment on your rental property you can use the rent money you collect from the tenants to pay down the mortgage. You won’t make a huge profit as long as the mortgage is being paid off, but once the mortgage is paid off you will have a nice profit and have a huge asset under your name.

2) Student Loan – investing in your education is always a good thing. People who have a university degree or college diploma make on average 10-20% more on their yearly salary than someone who only finished with a high school diploma. Getting a quality education is important since modern careers demand more education.

3) Debt for an Investment Where the Return is Greater than the Interest Accrued – in our example from above where $1000 was borrowed over a year and the interest accrued was $50 (at an annual interest rate of 5%), good debt would be if the loan was invested in anything with a greater than 5% annual rate of return. For example, if you were able to invest the money with a 7% return, you would have $1070 at the end of year. In this case you have made $20 out of nothing!

Bad Debt
1) Consumer/Credit Card Debt – this is the worst kind of debt imaginable. Imagine buying a pair of jeans for $50 and making the minimum payment on your credit card. Interest rates on credit cards vary between 10-20%, which is incredibly high. Making the minimum payment on your card for your jeans will end up costing you something on the order of $200 over 3 years. So the lesson here is to always pay down your credit cards otherwise you’ll be paying an exorbitant amount of interest.

2) Financing for a Vehicle – unless you get 0% financing on a vehicle, any financing on your vehicle is a bad thing. A car losses 15-20% of its value as soon as it’s driven off the lot. Not a good investment at all. If you have to make interest payments on an asset that is constantly losing value, it is not a good investment. In this case you should try to buy a used car and drive it as long as possible (this is how you get the most value out of your vehicle). Check out this archived article about purchasing a used car: http://reynold-savemoney.blogspot.com/2010/06/buy-used-rather-than-new.html. Car dealers love it if you pay for the car all at once, if you can pay for the car in full you can usually negotiate a better deal!

3) Mortgage on Your Own Home – the mortgage on your own home is not necessarily good debt. This is a drastic contrast from a rental property where the mortgage is pretty much paid by the tenants (good debt). In this case the mortgage on your own home is paid by you! You want to pay down your mortage on your own home as quickly as possible. Whereas for a rental property you could amortize (length of the loan) your mortgage over a longer period, as long as your payments are below the monthly rent you receive from your tenants. So in the case of the rental property, it creates cashflow. While owning your own home takes away from your cashflow. This is the reason why Rich Dad (Robert Kiyosaki) believes that your home is not an asset (http://reynold-savemoney.blogspot.com/2010/07/rich-dad-poor-dad-whats-asset.html). So be sure to pay off your mortgage quickly and perhaps rent out your basement to supplement your income and pay off your mortgage faster.


Here's another lesson from our Rich Dad:

3 comments:

  1. It's a good thing that I came across your blog. It's so highly informative things are posted here you should do more post like these. Thank you!:)

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  2. nice write up. i had two thoughts:

    - as far as school debt goes, it should be noted that yes...those loans are typically very low interest, and sometimes subsidized - however there is little wisdom in forking over $30k for a career path that will only pay $20k or so starting out.

    - as far as car debt is concerned, you were absolutely right - with the biggest losses in value occuring with american vehicles. however, purchasing a 'new-used' vehicle can be good debt. for example, you buy a Honda Accord at auction for $5k under value. yes it will lose value with time, but now there is a substantial amount of equity in the vehicle. it wont produde cashflow, but the equity does serve as a hedge against total-loss damages, and resale values.

    my two cents; thanks for the info!

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