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:

Rich Dad Poor Dad: What's an asset?

I hope that you've had a chance to look into some of the books about personal finance I've recommended in the past. Rich Dad Poor Dad is one that has been around for a while now. Robert Kiyosaki has created an entire brand around the title of this book which has its own line of instructional board games and personal finance seminars, not to mention a whole slew of other books. The ideas in his book can be a bit abstract sometimes but very insightful once you understand what he's getting at. There are many lessons in which he preaches in his book, I will try to go over a few of them briefly, but to get the full impact of the lessons it would be best to give it a read.

The story in which Kiyosaki tells is one of growing up with two dads. One is his biological father and the other is his best friend's father. Both have great influence over Kiyosaki as he grows up, but have very different outlooks on life and how to go about making a living. Kiyosaki's biological father is known as Poor Dad. He made a living as a teacher who eventually became the superintendent of the entire district school board. He always preached to Kiyosaki that he should get an education then get a secure well paying job. Kiyosaki's Rich Dad on the other hand made a living as an entrepeneur who owned several businesses. Rich Dad preached that the path to freedom and wealth was to own and operate businesses. Kiyosaki was always confused by the lessons taught by his Dads since they differed greatly from one another. Poor Dad's mentality on living life was very risk adverse while Rich Dad's mentality on living life was full of risk.

For now I'll leave that lesson about entrepeneurship since it can be very lengthy. I will be sure to post more on Kiyosaki's entrepeneurial lessons in the future. Another important lesson in his book is when Kiyosaki creates a definition for an "asset." He defines an asset as something that provides positive cash flow. He tries to explain how most people are confusing what an actual asset is, since a majority of people think there biggest asset is their home. Although you are building equity in home ownership, it does not provide a positive stream of income (unless it's a rental property). The important thing to note is that your home is more of an expense then it is an asset. Every month you have to pay property tax, utilities, a mortgage and maintenance fees. In the end you are working for your home, your home is not working for you. It does not actually put money in your pocket at the end of the day. Once you understand what Kiyosaki defines as an asset and can distinguish between what is an asset and what is an expense, than the path to true wealth is to gain as many assets as possible.

Rich Dad Poor Dad is filled with valuable lessons. I will have more posts in the future about the many different lessons from Rich Dad Poor Dad. The one thing that I really feel that this book lacks however is the concrete examples of how Kiyosaki would go about building wealth. He explains a lot of principles but does not go into to many details. He leaves it up to the reader to go out and get the information. The lessons are important and they are quite inspiring. I highly recommend starting with this book and reading some more of Kiyosaki's work in the Rich Dad series.