How Good Debt Works

There is good debt and there is bad debt. Good debt helps you to build yourself up. Bad debt works to overwhelm your finances and put you into the "spiral of death".

You use good debt to "lever" your savings into situations where you can buy assets far larger than you could ever save for in a reasonable time. Leverage is where you buy an asset by paying for a fraction of the full price from your cash and then borrowing the remainder of the total amount. A mortgage is by far the most common of good ways to owe. To get a mortgage you have to save up enough to put a "down payment" on a property. Then the bank will loan you the rest of the cost of the house. You make monthly payments to the bank to pay down the mortgage for an "amortization period" of 10 to 30 years. This means you are gradually paying off the loan. This is especially good if your mortgage payment plus taxes is very close to or lower than what you would pay for rent for similar accommodation. At the very beginning very little goes towards your principal but each month a higher and higher percentage of your payment becomes equity. If you rent, your rent money is gone forever. With a mortgage, your house turns into a savings account that you live in. Choosing which house to buy makes a big difference because there is a second way that you can gain by using a mortgage to own a house. In the long term, houses almost always increase in value over time. If you stay in a house or in a successful housing economy for decades, the value of your house increases in value. Over that amount of time there will price increases and decreases but over 10 or 20 or 30 years the average flattens out to about 6% per year.

So using 6% over the first 10 years the house you bought for $200,000 would now be worth $320,000. You put in $40,000 of your own money for a down payment. You would have paid rent anyway. The gain is $120,000. So what you have here is a 300% return on your $40,000 investment. You also have managed to pay down your mortgage by about $40,000, so you have also saved that amount. Let’s add this up. You have your original $40,000 plus you have paid down the mortgage by $40,000 plus you have gained $120,000 in market value increase. That means that your $40,000 down payment has grown into $200,000 of house equity in 10 years. Your cash flow is the same or better than if you had rented. You can see now why it is worth it to buy a house.

Not only is this a nice way to build financial security but also in most countries, the governments do not tax a financial gain on your principle residence. Some even let you reduce your income tax by a percentage of how much interest you pay on your mortgage.

However, please be careful. There are exceptions to the rule that the value of property will go up over time. There are still ghost towns created by the main employer closing the plant. Industries move and interest rates can climb to the point that when you renew your mortgage, the cash draw takes too much of your monthly income. Don’t buy any bridges or beach front property in the dessert. And do keep your property insured. This article was originally written before the sub prime mortgage crisis so these words of caution were somewhat prophetic.

All good debt is similar to the mortgage scenario. There are many versions of this theme. All have the similarity that you use debt to pay for something that will pay more back to you than you paid for it. Retirement savings plans are another example of using good debt to improve your financial security. In most cases money put in a Registered Savings Plan is tax deductible. If you can borrow money to put in your plan, I will assume 30% back as a tax refund, the first fact you have to appreciate is that you just got a 30% return on your investment in saved taxes. Then the principal will still earn interest all year and compound year after year. If you pay off that loan in 1 year, you are ready to leverage your cash assets again for another 30% return.

You can even take an extra year or two to pay it off and still be ahead. Once you have it in a Savings plan, all you need to do is preserve you first years gain within the safety of Guaranteed Savings Plans where principal is insurance protected and you get a mediocre but stable interest rate. You do not have to get fancy or get talked into "the best returns available." You have already outperformed the market by the tax saving. Do not risk losing your capital. Use safe compounding instruments where the principal is guaranteed to be the same when your bond or savings certificate matures.

For your retirement savings let’s do a similar exercise to the mortgage example earlier in this article. You can imagine yourself borrowing $3000 at 6%, pay it off in 2 years at $93 per month and put your $900 tax refund toward the loan. You invest your savings at 6% compounded return. After 2 years the debt is paid and you have $3370.80 saved. It cost you $2225.00. You gained $1155.80. That is over a 50% return in 2 years. You have got to like that. Try and find a mutual Fund that will give you that kind of return?

You don’t have to gamble or speculate to make big money. There is good debt and there is bad debt. Good debt helps you to build yourself up. Bad debt works to overwhelm your finances and put you into the "spiral of death".

You use good debt to "lever" your savings into situations where you can buy assets far larger than you could ever save for in a reasonable time. Leverage is where you buy an asset by paying for a fraction of the full price from your cash and then borrowing the remainder of the total amount. A mortgage is by far the most common of good ways to owe. To get a mortgage you have to save up enough to put a "down payment" on a property. Then the bank will loan you the rest of the cost of the house. You make monthly payments to the bank to pay down the mortgage for an "amortization period" of 10 to 30 years. This means you are gradually paying off the loan. This is especially good if your mortgage payment plus taxes is very close to or lower than what you would pay for rent for similar accommodation. At the very beginning very little goes towards your principal but each month a higher and higher percentage of your payment becomes equity. If you rent, your rent money is gone forever. With a mortgage, your house turns into a savings account that you live in. Choosing which house to buy makes a big difference because there is a second way that you can gain by using a mortgage to own a house. In the long term, houses almost always increase in value over time. If you stay in a house or in a successful housing economy for decades, the value of your house increases in value. Over that amount of time there will price increases and decreases but over 10 or 20 or 30 years the average flattens out to about 6% per year.

So using 6% over the first 10 years the house you bought for $200,000 would now be worth $320,000. You put in $40,000 of your own money for a down payment. You would have paid rent anyway. The gain is $120,000. So what you have here is a 300% return on your $40,000 investment. You also have managed to pay down your mortgage by about $40,000, so you have also saved that amount. Let’s add this up. You have your original $40,000 plus you have paid down the mortgage by $40,000 plus you have gained $120,000 in market value increase. That means that your $40,000 down payment has grown into $200,000 of house equity in 10 years. Your cash flow is the same or better than if you had rented. You can see now why it is worth it to buy a house.

Not only is this a nice way to build financial security but also in most countries, the governments do not tax a financial gain on your principle residence. Some even let you reduce your income tax by a percentage of how much interest you pay on your mortgage.

However, please be careful. There are exceptions to the rule that the value of property will go up over time. There are still ghost towns created by the main employer closing the plant. Industries move and interest rates can climb to the point that when you renew your mortgage, the cash draw takes too much of your monthly income. Don’t buy any bridges or beachfront property in the dessert. And do keep your property insured. This article was originally written before the sub prime mortgage crisis so these words of caution were somewhat prophetic.

All good debt is similar to the mortgage scenario. There are many versions of this theme. All have the similarity that you use debt to pay for something that will pay more back to you than you paid for it. Retirement savings plans are another example of using good debt to improve your financial security. In most cases money put in a Registered Savings Plan is tax deductible. If you can borrow money to put in your plan, I will assume 30% back as a tax refund, the first fact you have to appreciate is that you just got a 30% return on your investment in saved taxes. Then the principal will still earn interest all year and compound year after year. If you pay off that loan in 1 year, you are ready to leverage your cash assets again for another 30% return.

You can even take an extra year or two to pay it off and still be ahead. Once you have it in a Savings plan, all you need to do is preserve you first years gain within the safety of Guaranteed Savings Plans where principal is insurance protected and you get a mediocre but stable interest rate. You do not have to get fancy or get talked into "the best returns available." You have already outperformed the market by the tax saving. Do not risk losing your capital. Use safe compounding instruments where the principal is guaranteed to be the same when your bond or savings certificate matures.

For your retirement savings let’s do a similar exercise to the mortgage example earlier in this article. You can imagine yourself borrowing $3000 at 6%, pay it off in 2 years at $93 per month and put your $900 tax refund toward the loan. You invest your savings at 6% compounded return. After 2 years the debt is paid and you have $3370.80 saved. It cost you $2225.00. You gained $1155.80. That is over a 50% return in 2 years. You have got to like that. Try and find a mutual Fund that will give you that kind of return?

You don’t have to gamble or speculate to make big money. You just have to THINK YOUR MONEY especially when it comes to debt. Once you save don’t lose your capital and let compound interest be your best financial friend.