If there is one thing that is going to send your investment dreams to an early grave, it is debt. But not just any debt. I’m talking Bad Debt.
Yep, that’s right: Bad Debt.
It’s a nasty thing, Bad Debt.
Like everything that kills you slowly, Bad Debt seems innocent when you first meet it. Almost too good to be true.
At first, Bad Debt helps you get things that you’d really like to have but can’t afford.
Want the top of the range sneaker but only have enough cash for the mid-range? Not to worry – here comes AfterPay to bridge the gap!
Worried your modest car is damaging your personal brand? Sure enough, there’s a low-doc loan product for that too.
In no time at all, Bad Debt has you looking a million bucks.
When the interest bills start mounting up, steadily sucking your bank account dry like they’re drinking your money through a straw, you almost feel guilty for blaming Bad Debt for your woes.
Bad Debt was the giver of things, right? How can it be that Bad Debt is also the Killer of Dreams? Don’t people borrow money all the time to buy houses? Why is this so confusing?
And here is the catch: not all debt is created equal.
While Bad Debt makes you poorer over time, Good Debt is key ingredient to enable you to grow your wealth.
The trick comes in knowing the difference between the two, and how to use Good Debt to your advantage.
Good Debt vs Bad Debt
The easiest way to identify Bad Debt is to look at the things it helps you to buy. These are generally classified as “consumables”. Things that have a short shelf-life, and are eventually worth less than what you paid for them.
Shoes, clothes, holidays, cars, living expenses. If you’re borrowing money to buy these things then you are taking on Bad Debt.
Conversely, Good Debt helps you to acquire assets that increase in value over time. Generally, people associate different forms of property and some blue-chip shares with long-term growth prospects appreciating assets.
While not technically an asset, some people also consider education one of the most important investments you can make if it helps to grow your future income.
A broader term for Good Debt is Beneficial Debt, because the benefits that you acquire using the debt have long term value that far exceeds the cost of the debt.
These benefits can come from the appreciation of the value of the assets, or from the cash flow that the asset might generate.
The earlier you recognise this distinction the more likely it is that you will avoid Bad Debt. If you are looking to grow your wealth through investment and you are able to avoid, or eliminate, Bad Debt from your life then you will have a huge advantage over most Australians.
The Essential Role of Debt in Property Investment
Securing debt is often a necessary part of property investment, particularly when you are starting out. Without borrowing, many potential investors would find the market inaccessible. The ability to service a loan and maintain creditworthiness is crucial in this process.
Bad Debt affects your cashflow and impacts your borrowing capacity in ways that surprise many people. The high interest rates and short loan duration (ie less than 5 years) that often accompany Bad Debts can make it much harder to get a home loan to acquire an investment property because prospective home lenders need to factor in your existing financial commitments to servicing your Bad Debts.
For example, just $20,000 worth of combined unsecured debt (ie credit cards, AfterPay etc) would reduce your borrowing capacity by around $175,000. For someone trying to break into the property market, this could be the difference between getting into the market or missing out on a whole growth cycle.
Leveraging Debt Strategically
If you have already made friends with Bad Debt but you do have enough cash or equity to buy a property (or you already own one and have spare equity), one effective strategy involves your rolling high-interest debt into lower-interest debt, like a home loan. This doesn’t necessarily change it from Bad Debt to Good Debt (that would be like eating a hamburger and calling it a vegetable because it had a pickled cucumber inside the bun) but it does help to improve your cashflow.
By consolidating debts in this manner and reducing your interest costs, you can increase your rate of saving, thereby concentrating resources on growing your investment portfolio.
Once investors have created equity (by owning appreciating assets for long enough for their value to grow substantially) they have the option of using that equity how they wish. Some people will sell these assets to cash in their profits, but smart investors know that the longer the hold the asset the better off they will be.
Building a Successful Investment Team
If you’re keen to invest in property now, or in the future, and want to understand how to structure loans to give you the best chance of success, it’s vital that you have the right team in your corner.
An investment-friendly broker specialized in property can offer essential guidance. Accountants and other experts focusing on real estate investment can also provide invaluable insights.
Engaging with experienced portfolio managers and investment consultants can further assist in restructuring debts and maximizing investments, allowing investors to realize their financial goals through the wise use of debt. The notion of using debt to your advantage rather than fearing it offers a refreshing perspective on investment and wealth-building, emphasizing the importance of strategy, understanding, and collaboration with knowledgeable professionals.