Teh Chad

The debate on how any debt can be good is as old as currency. I’d like to talk about how debt can be good and how most debt is bad.

The true financial definition of good debt is debt that pays for itself. An example of this is a rental property where the tenants pay for the property loan, the taxes, upkeep, and all other expenses. The owner is paid a small sum after all of the expenses are paid for holding the full liability of the property loan.

Are the past two financial market implosions (housing and credit) making more sense now?

When someone mentions debt, most people think of their mortgage or their credit cards or their car payment. These are bad debts. They don’t pay for themselves. With those images in mind, it’s easy to see why nearly everyone thinks that all debt is bad.

Earlier in this blog, I posted a pretty long piece on the sides of the interest rate. This blog was very focused on getting out from behind the interest rate, or debt, and getting ahead of it, or investing.

The housing implosion was a result of a few things. People had become a bit too aggressive in their real estate investing. Many people were taking a small monthly hit to make sure they covered their expenses. In contrast, they could have been a bit more conservative and made sure that their loans would be covered by the value of the property.

Around this time, property values were going up and not slowly. When people bought property, they were paying a lot versus the true value of the property. This was coupled with the fact that banks were offering loans with relatively small down payments. These down payments are normally designed to offset any variance in prices for the given property. When prices blew up, initial principals, or down payments, should have followed.

As the bubble worked itself bigger, more and more loans were utilized with less protection. More people were vulnerable.

Then a few people lost their jobs as big companies turned out to be corrupt. All of the sudden, people could no longer take that small hit on their income properties since they didn’t have jobs. Their debt was bad. It was about to get worse. The housing market came full swing.

After a while, the banks put properties into foreclosure and sold them off where they could. However, there was a problem. The bank could not sell the property at a price to cover the loan. The borrowers still owed on a loan that was backed by a property that they didn’t own any more.

Property values dropped out of the sky. They reverted back to prices closer to their true value. Some might argue that property values have dropped below their true value. In places like Detroit and Las Vegas, I would certainly agree with that argument.

This, in turn, caused the credit crisis. Banks were seeing loans defaulted constantly. They were no longer making money. They called on the government. And the government can really only pull money out of the taxpayer pockets.

So, how do I find good debt? I don’t want to go broke and then be poor all of my life!

Finding good debt requires understanding of bad debt, ergo my discussion above. Then we must see that good debt pays for itself. I like the real estate example because it is so readily available in our society.

We have found a house that we think tenants will enjoy occupying. We must first make sure that we are not paying too much overall for the property. Then we must put an adequate down payment.

I keep reading about people who just put the minimum down. This is financial stupidity in my opinion. Not only will a solid down payment give a cushion against a downswing in property value, it will increase a property’s cash flow. This is very important as random expenses happen. Stoves fail and water pipes freeze. Properties need solid financing. Once that is done, tenants are happy to live in the property and pay you consistently for that privilege.

As owners and investors, it is important that we protect ourselves against these financial vulnerabilities.

In my few years on this planet, I’ve never learned to manage money real well.  My family has been in debt for as long as I can remember.  In the past couple of years, it seems that much of that has disappeared.  It didn’t seem like much changed other than my own career changing faces a few times.  So, I started reading.  There is a boatload and a half of information.  I like to think that I’m really smart, but I had a lot of trouble making sense of things and I didn’t have anyone who wanted to teach me.

Anyway, I’m a bit more visual and I like learning through applications.  This is my attempt to make things simple and clear for those of you who don’t get it, but want to.  Keep the picture handy.

When someone does something in business, they are looking to make money.  That is one of the most basic fundamentals of business.  When it comes to money, profit is usually measured in interest or return.  There are all kinds of loans.  And we usually get in over our heads pretty quickly.

We get credit cards and mortgages, student loans and car loans.  Each of these loans has it’s own interest rate.  I’m not going too deep into interest rates, but you really just need to know how it is accrued.

Interest is simply the rate of return (anywhere from say 3% to 25%) multiplied by the principal or money owed.

When buying something where the payments are relatively small in relation to the principal, the profit for the lender can be pretty substantial.  To give you a picture, let’s buy a house.  We are going to buy a house that costs $3 million dollars!  The current housing interest rates are somewhere around 5-6%.  For this, let’s use 5%.  Say you make only the minimum payment each month.  You will pay $5.8 million for your $3M home!

Now let’s look at a credit card.  A “low” rate for a credit card could be something like 9-10%.  They go lower, but we’ll use 10%.  Now, say you need to go visit your cousin’s friend, because his wife graduated from med school in like Heidelberg, Germany and your girlfriend went to high school with her.  The trip will cost you $5k and you go and have a REALLY good time!  Say that you can only pay like $400/month on that.  The minimum would be $125.  It will still cost you $5300 to take care of that debt.  Now let’s just make the minimum.  It will take you roughly 200 months and cost you $2400 in interest.  So you would pay 7400 instead of 5300. Notice the differences?

So have a look at the picture….

The purple represents the high interest debt.  Most of the time, these are just credit cards.  These debts will cost significantly more.  The red is the medium interest debts.  Car loans and unsecured loans usually fall into this category.  Then the yellow represents the debt that costs us the least.  These loans are typically long-term and the principals are usually bigger.

The more loans we have open further left, the faster we go broke EVEN with a job like CEO of a fortune 500 company.  So what do we do?

We work our butts off to get everything pushing right as fast as we can.  The top row represents a fairly typical picture of debt.  The purple is, of course, credit cards.  The yellow is probably a combination of student loans and maybe a house.  There isn’t a ton that we want to do about the yellow until purple is taken care of.  We want to make the minimum payments on those so that we have more to go after purple with.  (note: I’ve heard this called a few things from snowflake to snowball effect.)

But Chad!  I have like $53847 on my credit cards!  There’s no hope for me!

Ahem, let’s look at our picture.  The second row represents our current goal of eradicating purple.  How do we do that?  What if we took the equity in our home and took out a loan to cover the credit cards?  We HAVE to beat purple down with a stick as fast as we can.  The home loan is costing us much less than the credit cards.  We might have to secure a part of that loan with our car, which is no problem.

So!  Credit cards are paid and we are now in the middle row.  Congrats!  You’ve made your first steps to wealth.

From here, it becomes much easier to pay MORE than the minimum and really start eating into the principal of the new loan that is medium interest.  Once that is paid, we can look at beating out the low-interest loans.  The key is to pay as much as possible on the highest interest debt that we have.

Think of it like learning to be a warrior.  You learn how to get out of debt by making the biggest punches to your monthly payment.  Then as we progress into the bottom row, we have become the warrior we need to be to become wealthy!  We worked hard to beat down all of our debt and build equity in our house.  We have been frugal in our lifestyle and we have $100k in equity in our house.  We looked into buying another house and renting it.  And low and behold, we found a nice little house that already has tenants!

As we are paying more than the minimum on our home and the tenants are paying for that house…….

What was debt again?  :-J

TC