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:

Your Home - One of the Best Investments You'll Make!

After I published my last post I had a discussion with a friend. She said that she was now worried about buying a place to live since she always thought that purchasing a home was a good investment. My last post stated that Robert Kiyosaki author of Rich Dad Poor Dad did not consider a home as an "asset" since it does not generate cash flow. Because of this Kiyosaki believed a home is more of an expense than an asset. Without getting into details about how Kiyosaki defines an asset, I think that my friend is right and that your home is one of the best investments you will ever make.

First of all no matter what happens in life we all need a roof over our heads. When we rent a house or apartment money goes into the pockets of landlords. You can claim a bit of it on income tax but most of the money is loss. When you purchase a home however, whether it's a house or a condo, money is paid to the mortgage every month (given that you did not pay for it all upfront). With each mortgage payment a portion goes to the bank as interest and a portion goes to paying the principal of the loan. The interest portion is loss and is known as the cost of borrowing. The portion that gets paid toward the principal becomes yours and is known as home equity.

Now the reason Kiyosaki thinks that a home is not a good asset is that you only access your profits on the home when you sell it. Typically it is not a good idea to buy and sell your home over short periods of time since it doesn't have time to appreciate. With little time to appreciate your profits will be eaten up in real estate, lawyer, land transfer taxes, moving expenses etc... . So it's usually a good idea to own your place for a while before you decide to sell it again.

That being said there are other reasons why owning a home is good investment besides providing you with a place to live. Owning a home with multiple rooms can allow you to rent out some rooms to help pay for your mortgage which ends up as home equity. If you have a separate entrance to a separate basement apartment, even better! Another reason is that if you own a small home business you can expense part of your mortgage. Finally, owning property gives you incredible leverage. Leverage is the ability to take a home equity loan with your home as collateral. Banks will lend you money at a very low interest rate when it is backed by your property. If you default on payments however you can get your property repossed.

Why would you want to take a large loan out on your home? If you have any other debts that may be charging higher interest rates it would be best to pay them off using money from your home since the interest will likely be less. Also if an investments yields a higher rate of return than the interest you're paying on the home equity loan than you may as well be using money from that. Sometimes the bank will not loan money to finance a business idea or anything else you may want money for, if the bank thinks it's too risky. In this case a home equity loan is a no questions asked low interest loan. So with all those reasons to own what are you waiting for? Stop renting!