While there are multiple facets to successful investing – from asset selection to portfolio management – without doubt one of the most important determinants of success or failure is your relationship with debt. The reason? Well, if you’re looking to build a better life through acquiring assets, then appropriate borrowing and responsible loan servicing are part of the equation.
But awareness of how you think about and manage debt is crucial to your outcomes. There are those who know what they’re doing and are set to reap rewards. Conversely, some stay in a sour relationship with debt and eventually come undone.
Understanding Good vs. Bad Debt
You see it all the time in movies – the bad guys are sexy. They’re always living on the edge, stirring up trouble and leaving broken hearts in their wake. It makes for great drama – particularly when seemingly smart people are drawn into their orbit by their charismatic charm.
This is how it works with debt as well.
Bad debt has a magnetic power because it offers the promise of immediate gratification. It means easy money that’s on tap to fulfil your whims, and often with an easy justification for your purchase as part of the package.
Think about. Do you want a luxury car? Why not lease that thing and simply enjoy the longing looks from pedestrians as they admire your symbol of success? Feel like you need a holiday? Let the credit card carry you off to exotic lands and live like royalty. The bill won’t fall due for weeks.
Yes – these scenarios are appealing and thrilling, but like all no-good characters, bad debt will, in the end, break your heart.
Bad debt is where borrowed money is sunk into depreciating assets or some kind of ‘experience’. The types of purchases that will never yield a rising return in value.
And bad debt is often a gateway problem. Miss the payments and interest starts increasing the outstanding balance. Compounding debt begins to spiral out of control until you begin to disassociate yourself from it as being actual money that you are responsible for paying back. Solutions such as getting another credit card to pay off the previously maxed out credit card become desperately viable. It’s a viscous cycle.
The other problem with a bad-debt relationship is that it has long-term implications. Even if you can escape its grasp, bad debt plays out in your credit rating. Defaulting on a car loan in your 20s may well come back and haunt you when you apply for a mortgage in your 30s.
A silver lining
The flipside of the equation is good debt.
Good debt is where borrowed funds are used to buy wealth-building assets that grow in value (and provide an income) that not only offsets, but exceeds, the costs of the loan facility over time.
So, if you borrow money at an interest rate of 4.5 per cent and buy a property that sees capital growth of 5.0 per cent per year plus earns a net rental yield of 3.5 per cent, you are boosting the ledger.
The upsides are even better when compounding and leveraging are taken into account. Borrowing money for growth assets with adequate rental income means you can accumulate a larger investment portfolio. Certainly, much greater than you ever hope to acquire without using borrowed funds. Best of all, if you’re a sit-and-wait investor, the value gains keep compounding upon themselves. Before you know it, the asset has gone through a property price cycle and doubles in value!
Mend your debt relationship
Every person who has a plan to build wealth through investing needs to use debt, but it’s so often unreasonably demonised. Sometimes it’s fallout from a bad experience your parents had during financial tough times. Or it could be a cultural perspective about the evils of debt. Certainly, debt is bandied about in media and conversation like it’s a thing to be avoided.
I, however, believe debt should be embraced… but only the good kind.
It is, after all, just a tool to be used as part of your strategy.
Put another way, debt can be a great servant but can also be a very bad master.