Based in Los Angeles, The Money Smiths is a blog comprised of thoughts related to personal finances, real estate investing, and musings on early retirement.

Good Debt vs Bad Debt

Good Debt vs Bad Debt

To the average person, the concept of debt is associated primarily with negative connotations. You naturally jerk back from the thought of having debt and needing to pay it off each month, not wanting to commit yourself to a life of paying other people money forever. I used to be the same type of person, growing up I was always subjected to the thought that owing money to someone else was a sure-fire way to inhibit your ability to do what you want.  A few years ago I was introduced to the concept of good debt, which I touched on it very briefly in my post about how to start investing, where I explained that Mrs Money Smith and I are only interested in paying down debts that are above 7% because we feel that we can make our current money earn more than that.

The reason that we chose 7% was because we looked at other investments that we have, and realized that 7% was a safe number to choose as a minimum ROI (return on investment) that we could make using money how we saw fit.  For instance, our LendingClub account currently makes 10.33% with almost zero required work from me.  So technically, we could continue to pay down debts that cost us 7%, but if we can commit to making our money work for us we can receive 10% ROI with this investment stream alone.

So the question comes down to this- Do I want to pay off my debt and therefore make myself feel more comfortable with less money that I owe each month, or do I feel that what I owe each month is a comfortable amount that I can continue to pay without worry, and make my money work even harder for me? The answer for the Money Smiths is the latter, but we only got here by getting our debt paid down to that required level of comfort.  This is a key piece of the equation that’s worth reiterating, because if you try to get your money working harder for you before you’re in a comfortable spot financially, you’re only going to struggle to continue to let your money work.

The saying that the rich get richer is one that I would back up over and over again. I think that the saying can be misunderstood with these terms though, simply because the idea of being rich is generally so much more than we personally think we can get to, that it feels like an unreasonable idea to even strive for it.  That’s an excuse that plenty of people make, and plenty of people reading this blog will make. But if you stick to your plans and focus on getting yourself to a reasonable amount of debt first, you can focus on your growth.

Let’s get back to that good debt/bad debt thing though...I’ll start with some definitions:

Bad Debt: Money owed for purchasing something outside of your means on credit.

Good Debt: Money owed for purchasing something outside of your means on credit, that makes you more money than you owe.

Let’s dig deeper into the definitions - The only difference between the two is that good debt also makes you money.  “But Mr Money Smith!” - you cry out…”you shouldn’t borrow money to make money, that’s a super risky position to put yourself in!”...To which I would reply that you’re not completely wrong.  I’m going to get deeper into investing here, which should always come with the caveat that investing is inherently risky, and each person has their own idea of a healthy risk tolerance. Good debt can be seen in many different ways, such as buying an investment property, (which is my personal favorite way to use it), or buying stocks on margin, or short selling those stocks.

Honestly, you likely won’t see any stock market advice from me, because I’ve decided that the stock market isn’t somewhere where I should spend my energy.  But let’s dive even deeper now into my example with real estate. Most people will purchase a house in their lifetime, it’s incredibly common to purchase houses with mortgages, which by themselves are considered bad debt (by my definitions above).  If you take out a mortgage to buy a property that you rent out, you’ve now successfully turned your debt into good debt. This is obviously a high level approach to the concept, but it helps drive the point home. I’ll get into numbers in just a second.

Let’s take these two scenarios and play them out a little to see what they look like:

Scenario A: Mr Short-Sighted decides that he wants to buy a home, this will be his first home, and the biggest purchase he’s ever made in his life.  The home can be purchased for $100,000 after closing costs. The bank is willing to give Mr Short-Sighted a loan of $80,000 to help pay for his house, and only asks that he pay a 5% APR (Annual Percentage Rate).  Mr Short-Sighted looks at this deal and thinks everything is going swimmingly and agrees to purchase the home, signs the mortgage, moves in, and continues to pay the loan off for the life of the loan, we’ll use 30 years.

Scenario A looks like this:

Initial Money Down: $20,000

Initial Mortgage Note: $80,000

Monthly Payment: $429.46

Total Amount Paid in 30 Years: $154,604.63 (This is calculated with the monthly payment over 360 months)

Mr Short Sighted wasn’t able to save any extra money with his house purchase, but he was able to pay off his house and now has an asset that likely appreciated in value over the last 30 years, and now can finally use the $429.46 he’s been paying every month toward some investments, seeing as he’s nearing retirement age and should start thinking about that. He’s content with his life.

Scenario B: Mr Friendly decides that he wants to buy a home, this will be his first home, and the biggest purchase he’s ever made in his life, (sound familiar?).  The home can be purchased for $100,000 after closing costs. The bank is willing to give Mr Friendly a loan of $80,000 to help pay for his house, and only asks that he pay a 5% APR. Mr Money Smith looks at this deal and thinks everything is going swimmingly and agrees to purchase the home, signs the mortgage, moves in, and pays the loan off for the life of the loan.  He also decides that because he is living in a home with three bedrooms, he can rent out one of the bedrooms to supplement his mortgage payment, and decides to rent to Mr Cheapo. Mr Cheapo agrees to pay $300 dollars in rent a month.

Scenario B looks like this:

Initial Money Down: $20,000

Initial Mortgage Note: $80,000

Monthly Payment: $429.46

Total Amount Paid in 30 Years: $154,604.63

Monthly Rent Collected: $300.00

Total Amount Collected in 30 Years: $108,000

Total Amount Paid by Mr Friendly: $46,604.63.

At the end of this 30 years, Mr Friendly has also purchased other investments with the $300 he hasn’t had to use and has purchased other properties, netting him even more money.  This example uses renting a room to a roommate, and is definitely not something that every person would want to do with their lives (especially for 30 years!!). Let’s dig into one more bonus scenario to see what this could look like if we decide to play our cards a little differently:

Super Awesome Bonus Scenario: Mr Money Smith realizes that he can purchase the same home for $100k, and rent out the entire house to someone for $850 per month. Granted, this means that Mr Money Smith will have to find somewhere else to continue renting since he also needs a place to sleep, and is able to find a room for rent for $300 per month.

Bonus Scenario looks like this:

Initial Money Down: $20,000

Initial Mortgage Note: $80,000

Monthly Payment: $429.46

Total Amount Paid in 30 Years: $154,604.63

Monthly Rent Collected: $850.00

Total Amount Collected in 30 Years: $306,000

Total Amount Netted by Mr Money Smith: $151,395.37

That’s right, Mr Money Smith actually made more from the purchase of his house, than the actual cost of the house!  The other added benefit of this scenario is that Mr Money Smith was also able to buy an identical house in just under four years, that was completely paid for by the income of the first house (I calculated this by taking the difference between the rent and the payment, and dividing the required $20k down payment by that amount).  This is because Mr Money Smith was smart enough to leverage the banks money, in the form of a mortgage, to pay for a house initially, that he convinced someone else to pay down for him. The downside is that Mr Money Smith had to live with roommates for a couple years, but he was ok with that because he knew he was investing in his future.

This is my example of good debt.  These numbers are made up for the purposes of having an easy to use number, but aren’t uncommon either.  This also isn’t too far off from what Mrs Money Smith and I did with our first house, except that we purchased a multi-family property and lived in one unit, while having the other two pay our mortgage for us.  If you want to see examples of real numbers, you can see more about that property HERE. These examples are just one way to show how you can use debt to your favor.

I hope this post has started to make you think about what other ways you can leverage debt to your advantage, instead of always being something restrictive. Now’s the part where I’m curious to know how you’ve been able to successfully acquire good debt.  What ways have you been able to help your future self out, by jumping on an opportunity to have someone else pay for your assets?

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Our First Investment Property

Our First Investment Property