Good Debt, Bad Debt: How to Stay on the Right Side of Leverage

Debt is commonly regarded as a bad thing. And on the surface, that makes sense. Personal finance advisers preach against debt. They offer advice like freezing your credit cards in a block of ice, paying down your mortgage as quickly as possible, and never splurging on a $5 latte as ways to avoid or eliminate debt.

But debt is a tool, just as a hammer is a tool. A hammer can do a lot of damage, especially if you hit yourself over the head with one. But it can also help you build a house. The same principle applies to debt.

That’s why you’ll observe smart real estate investors, those people growing legacy wealth, excited about accumulating more debt to acquire properties. There is a difference between “good” debt and “bad” debt.

“Bad” debt is used to purchase things that do not produce more money. “Good” debt makes money by being invested in assets that produce income and capital gains.

I am often asked whether certain assets or liabilities should be considered a “good” debt or “bad” debt, or if there is a “good” interest rate and a “bad” interest rate. But there is no rule that a certain interest rate constitutes good debt or bad debt. Most consumer debt, including credit cards and personal loans, falls into the latter category, but it’s not because the interest rate is over 20%; rather, it’s because the money is used for consumer spending that will create little to no growth or income.

For example, a 4% student loan sounds like a great deal. But if it earns Junior a college degree that doesn’t help advance his career, that 4% loan would be bad debt, because it creates little or no growth or income. In contrast, good debt could be a 12% interest rate on a bridge loan to acquire an apartment building that produces 15-25% a year profit. And if the funds required to service the debt ( interest payments plus principal payments) come from the investment itself (i.e., the tenant’s rent pays the mortgage for you) the loan is essentially free and even creates cash flow.

But the sophisticated investor looks at cash flow and the impact on net worth. Cash flow is the figurative oxygen that keeps you financially alive, and the impact on net worth is monitored by the percentage of return of equity.

Think of it this way: If you had to wait till you had all the money in hand before you could purchase a rental property or a home, you might never acquire any asset that had the potential to create cash flow above the interest rate payments.

Semi-sophisticated investors may avoid leveraging themselves to the max by taking a loan-to-value ratio of less than 80%, considering this to be “safer.” However, putting up a larger down payment may drain your cash reserves. The savviest investors know that security lies in the monthly cash flow, which builds up a large cash reserve account. On the flip side, taking out a smaller loan for a smaller asset will yield less cash flow.

Investing without debt is like cooking without gasoline: Of course, gasoline can be dangerous, but if we learn to use it properly, we can see better results. Investors who use debt wisely can transcend the current money paradigm that most people live by. Numbers people see it as a simple argument of interest/return rate arbitrage where they pair a lower interest rate with a higher rate of return. A game of arbitrage is at the core of the banking industry.

Is Your Debt Good Or Bad?

To evaluate your investments and create an action plan, write all your debts and assets out in a list.

Write down the description, balance amount, interest rate per year and what income it is producing as a percentage per year from the initial cost it took to acquire that asset. Identify which assets are producing the least amount of money after paying off the debt service (interest). Some of these may be negative. Consider selling or liquidating some of those in order to acquire assets that produce positive income.

Real estate is a time-tested asset that produces income and is a commodity where the demand is not going away. However, it’s advised to also consider other assets that produce income.

It will take some time but if you prudently leverage your holdings with more and more good debt, you will be able to reap the rewards of a guilt-free, bad-debt splurge such as your dream car, vacation home or private-school education for Junior, because it will be paid off by the cash flow from the other good debt investments. In those situations, you will find a new level of ownership of that purchase because you truly earned it.

Lane Kawaoka owns 2,600+ rental units and the leader of “Hui Deal Pipeline Club” which has acquired over $155 Million dollars of real estate by syndicating over $15 Million Dollars of private equity since 2016. He uses his Engineering degree to reverse engineer the wealth building strategies that the rich use in the SimplePassiveCashflow.com podcast. He will be speaking at FreedomFest at the Paris Resort in Las Vegas July 17-20.

 

 

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