“Debt” The word alone makes most people cringe. After all, at some point in our life most of us have felt overwhelmed by debt. But let’s not forget the good it has brought us. With very few exceptions, where would we be today without it? Did debt help you buy your first home or car? Did it help you get your education or start your business? So how do we distinguish between the good, the bad and the ugly when it comes to debt?
“Bad debt” is dangerous. It is like standing in the bottom of a pool with bricks tied to your feet and feeling the water slowly begin to rise. The most widespread cause of bad debt is credit cards: you are actually borrowing money at a ridiculous interest rate that the minimum required payments will seldom - if ever - be able to offset. However, any type of debt can be bad debt—cars, home, business. Bad debt can really be defined as debt created without a budget. In other words, your budget should determine the amount of debt you can handle. We have taught many financial planning classes and seminars through various universities in Texas over the years and the most important lesson has never changed—the need for a personal budget.
A personal budget allows people to see exactly what they are spending and where they are spending it, as well as provide a financial roadmap for the future. How do you know what kind of income you need today, tomorrow, or during retirement unless you put a pen and paper to it? How do know if you can afford to finance a new home unless you put a pen and paper to it? You can’t. Yet many individuals and their families overlook or avoid this step. And it is quite often these individuals and their families that end up living outside their means, compounding their debts, and consequently and unnecessarily, increasing their fear of debt.
In reality, there is such a thing as “good debt." Good debt can be defined as a liability that is temporary, necessary, or prosperous. For instance, a farmer needs to purchase fertilizer for his coastal this year in the amount of $20,000. He uses his line of credit at Ag-Texas to purchase the fertilizer. Upon the sale of the hay, he pays off his loan. Would it be good to liquidate an investment earning 5% per year in order to pay cash for a vehicle when you can afford to make the loan payment with a 0% interest rate? What about something as simple as your home loan? Most homeowners make a loan for a large portion of the purchase price. Over time the value of the home increases. The homeowner should eventually be able to sell that home at a higher value, generating a greater profit than he would have realized by buying a home that only his down payment could have purchased. On a bigger level, this strategy – commonly referred to as a “Leveraged Purchase” - is used often with investment real estate. Consider the two comparative illustrations below.* The “Leveraged Purchase” produces approximately 79% higher return.
Cash Only Purchase Today
$100,000 Value Today
5% Income each year on original $100,000
3% Growth in value each Year
10 Year Picture After Sale
$50,000 Income received over 10 years
$134,391.64 Selling Price of Real Estate
$84,391.64 Total Gross Profit (184,391.64-100,000)
Leveraged Purchase
$200,000 Value Today
$100,000 50% Down Payment
$100,000 Loan at 3.25% Interest After Tax Savings
5% Income each year on original $200,000
3% Growth in value each Year
10 Year Picture After Sale
$100,000 Income received over 10 years
($17,262.83) Interest Paid
$268,783.28 Selling Price of Real Estate
$151,520.45 Total Gross Profit (268,783.28+100,000-17,262.83-200,000)
Another question that comes up often is “Should I take the cash I have and invest it or pay off my mortgage.” Imagine having the choice between paying 100% cash for a $200,000 property or using the “Leveraged Purchase” strategy and leaving the other $100,000 invested with an annual return of 8%.
Cash Only Purchase Today
$200,000 Value Today
5% Income each year on original $100,000
3% Growth in value each Year
10 Year Picture After Sale
$100,000 Income received over 10 years
$268,783.28 Selling Price of Real Estate
$168,783.28 Total Gross Profit (368,783.28-200,000)
Leveraged Purchase
$200,000 Value Today
$100,000 50% Down Payment
$100,000 Loan at 3.25% Interest After Tax Savings
5% Income each year on original $200,000
3% Growth in value each Year
$100,000 Invested Growing at 8% annually
10 Year Picture After Sale
$100,000 Income received over 10 years
($17,262.83) Interest Paid
$268,783.28 Selling Price of Real Estate
$215,892.50 Value of $100,000 Investment
$267,412.95 Total Gross Profit (268,783.28+100,000+215,892.5-17,262.83-200,000-100,000)
Everything you do involves risk. The risk when you apply leverage to real estate is obvious, but what about the risk of putting all of your liquid assets in real estate or relying on your home or one property to increase in value. These are often overlooked risks.
Here are two quotes I would like to share with you. The first is a quote for those who worry they should know everything about their finances and feel embarrassed that they do not. The second is for those who know everything about their money.
I know that I do not know—Socrates
Sometimes it is what you don’t know that you don’t know that will be all the difference in your planning. If Socrates was okay with it, perhaps you should be too. After all, conceding may make or break you in the end.
Knowledge is knowing a tomato is a fruit. Wisdom is not putting it in a fruit salad.—Miles Kington
You do not have to personally make a fruit salad with tomatoes to realize it is not a good idea. We often talk about the experiences we have lived through the lives of our clients over the years. You can have all the education in the world, but these experiences create the wisdom necessary to do our job effectively.
*Please note these are all artificial numbers, returns and rates. Nothing stated is implied guarantee. None of this should be taken as individual advice. You should work individually with your financial advisor and other necessary professionals to customize a plan to fit your needs.