Updated: Jan 1, 2021
We were probably taught at a young age that debt is bad. We should always pay down our obligations and put some money away in our savings to make sure we are financially sound in the future. What if we were to tell you it depends? Debt can be broken down into 3 different categories the good, the bad, and the ugly. There is a big difference between the three. If used properly debt can be a powerful tool in business and in your real estate investment journey. It can provide the needed leverage to expand operations, improve efficiencies, and help reduce costs. Beware though - debt is a double edge sword and must be used with caution – it can quickly spiral out of control if not monitored and assessed for all risks.
Ugly Debt or Consumer Debt is probably what most people are familiar with. This can include a wide range of products and services like clothes, furniture, and entertainment to name a few. The value of these items depreciates on Day 1. It is always important to spend only what you make – using debt to support a consumerism lifestyle is a disaster waiting to happen. Ensuring that each week you have less outflows then inflows out of your chequing account is critical for financial independence. If you have accumulated this type of debt the focus should be to pay it off instantly. For this category, if you do not have the cash in your bank account then simply do not buy it. The only reason we ever use our credit card for this type of spend is to collect points and cash rebates. As soon as we make the purchase, we immediately transfer the funds to pay off the outstanding balance.
Now let us talk about Bad Debt that most people ignore – your personal residence and vehicles. A lot of people consider these two as assets – in fact when we put in our applications through the bank, they often ask us to list our assets which include these two categories. This is because there is some value in both – the only problem is they do not produce any money for you and your family. In fact, they do the completely opposite – they are monthly obligations. Each month you are paying into these two asset classes – its money coming out of your account – therefore its bad debt.
A vehicle is sometimes useful to get you to and from work. If a vehicle is a requirement for your family, then its important to understand your needs vs your wants. A car has a wide range of options and prices. It is extremely easy to get caught up in what is “nice to have” vs “requirement”. This is where you need to draw clear line and make the decision. Whatever options you chose – just remember vehicle values depreciate over time. You will not only have monthly payments [if you chose to take on debt] but the value will also erode and eventually be worth $500 that you would receive at the scrap yard. Try to avoid taking on this bad debt as much as possible. You can do so by saving, taking public transportation, or simply purchase based on need. Other ways to minimize your obligation in this category is to buy a used vehicle, sign up for basic options, and/or purchase an economy brand.
A personal residence [by some] is considered one of the best investments they have ever made. Its important to break down why people tend to think this and why a personal residence is bad debt. For most people it is exceedingly difficult to save/invest money. A house obligation is the last payment that most people are willing to default on because shelter is one of the 3 basic needs for survival [Shelter, Food, Water]. In a way the principle that gets paid off every single month is a forced savings plan for most people. The residence also goes up in value, so by the time that the house is fully paid off, quite a bit of equity is built up. So, when the owners decide to sell, they can cash in. What most people do not consider is the interest payments, maintenance, and taxes that they had to pay along the way. The returns end up being much lower than what it looks like at first glance but the biggest problem with owning a home is that it does not produce any money until its sold. Until there is money in your pocket, its an obligation and its important to recognize this early on to avoid making costly mistakes. In fact, according to StatsCan the average Canadian spends about 29.2% of their income on shelter. This is a big dent to monthly cash flow. There are strategies to minimize this or make it 0% altogether but we will leave that for another blog. The main point we are trying to convey is that if its not putting money in your pocket its bad debt.
Good Debt is a powerful tool that can be used to not only build wealth but also accelerate it exponentially. This debt helps create income streams each month. These assets include but not limited to purchasing companies and real estate.
Through debt leverage our returns on these assets can be multiplied. Below is a simple example if you had $50k cash. In scenario 1 [no debt] at 10% return you will be walking away with $5k however in scenario 2 we use debt leverage to provide us with a bigger stake and return. We assumed 80% [$200k] debt and 20% [$50k] cash totaling $250k invested. The returns are still 10% but this time we are seeing 5x our initial return with just cash. Do not forget we still need to pay our lender – in this case we used 5% as interest for the loan. At the end of the day you are walking away with $15k or 3x what you would have if you were to just invest cash without any debt leverage. Now imagine you replicated this again but this time with the additional money that was made from the previous deal. It seems like an unfair disadvantage to those investing with just cash.
This is not any different with how businesses operate. They all use some sort of leverage to impact/increase their bottom line. A company might use it to expand operations due to the high demand in foreign markets or invest in new technology that will make their production line more efficient. You see debt is a powerful tool when used correctly. It can help you accelerate financial independence like it helps businesses grow around the world. It all really comes down to increasing cash flow payments each month and debt can help achieve this.
It is a mindset change. People tend to buy these “nice to have” things in early stages of their life. This accumulation of bad debt makes it difficult to invest in ASSETS that generate revenue streams for today and the future. The approach should be to invest in ASSETS today - that generate income. This in return will allow you to pay for the “nice to have” things that you want plus more. Investing today, helps you get to the next stage. Using good debt can be extremely helpful in achieving not only big returns but also accelerating financial freedom.
If you’re interested in finding out more information on how you can invest with us on our next deal –reach out to us directly at 289-242-6294 or email@example.com.
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The information provided in this blog is for entertainment purposes only and is not intended to be a source of advice with respect to the material presented. The information contained in this blog do not represent legal or financial advice and should never be used without first consulting with a financial professional to determine what is in your best interest to meet your individual needs.
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